Lucas Paradox and the International Flow of Capital - Coursework Example

Lucas Paradox and the International Flow of Capital and Lucas Paradox and the International Flow of Capital Lucas paradox is the observation that capital does not flow from rich countries to poor nations despite that poor countries have lower levels of capital per worker. It disputes the neoclassical theory that states that capital always flow from capital surplus areas to capital deficit areas. Lucas uses three reasons to explain why the theory no longer holds and includes differences in human capital, external benefits in human capital and market imperfections. Under the egalitarian prediction of the neoclassical model of trade and growth are based on technology alone. It explains about two countries producing same goods with same constant returns to scale production function, relating output to similar capital and labor inputs. The production per worker differs between the two countries because they have different levels of capital per worker. The law of diminishing returns states that marginal production of capital is higher in the less productive or poorer economy. That means that if the trade in capital goods is free and competitive, new investments occur only in the poor economy until capital labor ratios, therefore, wages, and capital returns are equalized (Lucas, 1990, p.92). This would mean that capital would flow from developed economies to poorer economies as they seek to exploit investment opportunities. The financial resources would be used to improve their physical capital such as industries, machinery, and infrastructure, which makes the poorer economy better off. With increased globalization, it would mean that more capital also flows to less developed economies (Prasad, Rajan, and Subramanian, 2007).However, this does not happen and what flows is only in small terms and Lucas investigates why this does not happen as explained in the neoclassical theory. This paper seeks to explain the Lucas paradox and explain why there are low capital flows from rich countries to rich countries. Lucas (1990) compares the United States with India, where production per person in the United States is 15 times what is in India. By use of the production function: y= AXββ, where y is income per person, x is capital per worker. Marginal product of capital is r= Aβxβ-1 in terms of capital per worker. In terms of productivity per worker r= βA1/βyβ-1/β Let β=0.4 then marginal product of capital in India must be 151.5=58 He argues that according to the neoclassical theory, the marginal product of capital in India would be 58times what is in the United States. This would mean that if world market were free and complete, then all capital goods would flow from the United States to India, rapidly. It would also flow rapidly from other wealthy nations to the extent that few, if any, investment would be in the United States in view of the returns in India. In practice, there are no such observations and Lucas questions the legitimacy of the assumption that gives rise to the differences in the marginal product of capital and seeks to find assumptions that should replace them. According to Lucas, this is the central question of economic development. Lucas states that with some modifications of the neoclassical theory, the paradox can be eliminated. He states that the differences result from differing in human capital, external benefits of human capital and market imperfections. Differences in human capital can be shown by the studies conducted by Anne Krueger in 1964 on per capital income between different countries and mainly base the difference resulting from education, age and sectors between the countries. The research had found that if age sector distribution in the United States and India were similar, an increase of 1% in the education in India would cause an increase of 32.6% in capital income. If income and physical capital per worker is the same, then the estimated fraction per capital income relative to the United States is nearly the same for Canada (100.5%) but smaller in India (38.2%). All other factors being held constant, this difference is caused by differing in human capital (Pogoda, Clemens, and Wigniolle, 2012). The effect amount the human capital effect has on the marginal return on capital can be investigated. Let interest rate in the United States be ru and in India be ri, income in the United States be yu and yi in India, if β=0.4 and yi/yu=15 from data obtained by Anne Krueger. Then ru=βA1/βyuβ-1/β ri=βA1/βyiβ-1/β ri= ru. (yi/yu)β-1/β ru · 151.5 = ru · 58. This showed that marginal return on capital equaled to 58times that of the United States. When Lucas calculated the marginal return on capital from the adjusted figures, he found that the marginal productivity of one United States citizen equaled five Indian citizens. y1/y2 value 15 decreases to 5 ri=ru.31.5=5.2, which is approximately 5. Even if aggregate production functions in poor countries were identical to those of richer countries, it does not follow that the poor countries’ relatively owning of labor and natural resources would result in very high return to investment in physical capital (Caselli and Feyrer, 2007).This is because owning other factors also matters especially human capital in the form of the health and educational levels of the labor force. Healthy workers are more productive than unhealthy workers are. Diseases such as AIDS, which are prevalent in poor countries, affect their health and productivity. To explain external benefits of human capital, Lucas assumes that marginal product on capital in the same. Differences in having different output in the two countries are explained by level of technology used. Lucas (1990) explains level of technology as the average level of the workers’ human capital for each economy. He raises it to a power such that the production function changes into: y = Akβh^γ where y is the income per effective worker, k is the capital per effective worker and h is the human capital per worker, and h^γ is an external effect on y. Therefore, higher human capital per worker increases the output and the assumption of a shared common technology may not be appropriate. The technology available to firms in poor countries is less productive than that available in rich countries, therefore, rates of return in investments in physical capital in poor countries is less than in rich countries. The level of skill in a country’s plays an important role in its ability to adapt and implement new and more creative technology (Tornell and Velasco, 1992). In addition, the productivity of capital using existing technologies may also depend on the skills of the labor force, for instance, literacy, formal education, and industrial experience. Other factors such as teamwork, rate of turnover, and job performance is different between citizens of poor and rich countries. In addition, technology transfer may be limited to poor countries because of lack of industries that use the technology, transport cost in transferring the technology to the poor countries due to underdeveloped infrastructure. It could also be because poor countries are usually recipients of the products made, therefore, they do not adopt it and because technology may require highly skilled labor which may not be available in poorer countries (Basu and Weil, 1998). To explain the differences because of market imperfections, Lucas explains that although there are higher returns in poor countries, there is market failure or international capital market. It can be explained by the following production function: Let production function in colony be y=f(x) Then monopolistic problem is to choose x so as to maximize f(x)-(f(x)-xfi(x)) –rx, total production less wage payments at a competitively determined wage less the opportunity cost of capital. The first order condition of this problem: fi(X) =r-xfii(x)i However, he explains that before Third World War 1945, market failure cannot be blamed for the lack of capital flows between the nations. This is because most of the poor nations were under the European colonialism and there was enforcement of the European legal systems, which also meant enforcement of contract was similar to a European country. Lucas paradox can also be explained by missing factors of production in poor countries. Poor countries have lower capital flows because of the existence of other factors such as human factors and land that had not been included in the neoclassical theory. Labor and natural resources consist of only a portion of the factors of production that correspond to physical capital. If poor countries’ relative endowment of other complementary factors is less favorable than that of labor and natural resources, it may reduce the rate of return to physical capital in the poor countries. The poor countries are less endowed with human capital and infrastructure. Prescott (1998) adds that if human capital affects capital returns, then fewer capital returns flows to countries with lower endowment of human capital. This can be explain by the production function: Yt=AtF (Kt, Zt, Lt) where Y represents output, A total factor productivity, Kt capital, Lt labor and Zt denotes another factor that affects a production process. Government policies can also act as a hindrance to flow of capital between nations. This is because there exists differences in tax policies, which lead to significant differences in the capital-labor ratio. Increase in taxes leads to higher cost of investment, which in turn leads to lower profitability. Countries with higher levels of inflation also discourage flows among the countries. In addition, governments may also put restrictions on capital flows. The independence of the judiciary and legal framework also plays an important role in solving disputes in a free and fair manner and enforcement of commercial contracts. Government stability influences capital flows in a nation in that a country with a stable government attracts more flows than a country with little stability. A government policy on privatization also influences capital flows in that it is easier for flows to a country with higher flexibility in privatization than in a country with a rigid privatization policy. In addition, some government regulations limit activities in which foreigners can take part and have red tape and bottlenecks in carrying out the activities. Such regulations create obstacles for foreigners to invest in poor countries, thereby reduces capital flows (Gourinchas and Jeanne, 2013).Macroeconomics instabilities in poor countries have also discouraged flow of capital flows. This is because high prices, wages, and interest lead to lower profitability in investments. Macroeconomic instabilities in poor countries are in the form of an overvalued exchange rate, trade restrictions, and heavy taxations, which lead to a decline in the flow of capital. Since investors seek to maximize profits are concerned with the net return to capital, the maximum amount of foreign capital directed to the country would be determined by the new capital market equilibrium condition: Atf0 (kit, zit) (1 − τit) = rwt where τ represents government policies and in general uncertainty, kit refers to the capital stock per worker derived from the capital market equilibrium condition in the open economy context (kcm) and rwt is the world interest rate. The new capital market equilibrium stock of capital (kcm) is achieved through foreign investment, and once it is reached, the steady state capital stock kss is the result of subsequent domestic investment (Sanchez, 2006). Institutional structures also contribute to capital flows within nations (Alfaro, Kalemli-Ozcan, and Volosovych, 2008, p.348-349). Institutions refer to rules, laws, constitution, traditions, and customs of a particular nation. They shape the structure of an economy and include political, social, and economic factors in a society. These factors affect investment decisions through protection of entrepreneurs against government and other segment of society that prevent them from adoption of technology. A society or nation with weak property rights leads to poor institutions, which in turn lead to lower productive capacity, raising doubts over returns (Bryant 2006, p.9). They also affect the efficiency of productivity in a country. A society or institution that restricts use or adoption of technology has fewer flows compared to one that allows higher usage of technology. A society that has low levels of corruption also has higher flows of more capital than that with higher levels because it increases foreign direct investment (Wei, 2000). Capital flows are also affected by level of bureaucratic quality present in a society such that higher levels attract higher flows of capital. Capital inflows influence institutional quality of a country in that incentives lead to a more investor friendly environment (Rajan and Zingales, 2003). Capital flows in the international market is restricted by asymmetric information. This refers to a situation in which one party in a transaction has less information compared to another (Alfaro, Kalemli-Ozcan, and Volosovych, 2007). It means that lenders cannot effectively monitor investments of the borrowers, and investors have inadequate information on a market, therefore, they do not invest thus hinders capital flows in the poor country (Alfaro, Kalemli-Ozcan, and Volosovych, 2008, p.350). Distance is a factor in the ability of investors to access information about a market because a country that is less visited is not fully exploited due to limited information being accessed. In addition, people in poor countries do not travel often outside their countries. Wei and Wu (2002) explain that distance is one of factors that determine whether a bank lends to invest in a foreign country. Lenders are reluctant to finance projects that are in poor countries because they are in a distant place where they have little information even if the project has high returns (Montiel, 2006). Inadequate information can be attributed to the reason that foreign investors are more willing to invest in their domestic market than in the poor countries’ markets, which have limited information accessible (Portes and Rey, 2005). Another factor that limits the flow of capital is sovereign risk. This refers to a country defaulting in its debt payment obligation to foreign lenders, takes over their assets within its borders, and prevents domestic citizens from meeting their loan obligations in foreign contracts (Ju and Wei, 2006). It could achieve this through changes of laws and causes losses to investors. Many poor countries have many debts, which they have defaulted. This defaulting leads to fewer flows of capital in poor nations due to political risk. It also means that most of foreign direct investment is in a form of merger acquisition and takeovers rather than through equity. In addition, defaulting in payment means that poor countries have a hard time borrowing from other countries. Some poor countries have a high rate of non-repayment of 65 percent, which scares capital flows from rich countries to poor countries (Reinhart and Rogoff, 2004). Poor countries have difficulties servicing their current loans increasing sovereign risk (Reinhart, Rogoff, and Savastano, 2003). Countries with high levels of debt are also likely to increase taxes on business and especially on foreign capital and multinationals, which in turn scares capital flows (Montiel, 2006). Poor countries that have fast-growing economies have better investment opportunities, therefore, attract more foreign direct investment (Borensztein, De Gregorio, and Lee, 1998). However, they do not always utilize more of the foreign capital but they export it to other countries for instance China, which is a third world country, is a big net exporter of capital. Scarcity of foreign capital hurts poor countries and countries in that they receive less flow of capital making them to have a slower growth, which in turn reduces investment opportunities available. Hoffman (2002) explains that low developed infrastructure is a reason for the low flows of capital between the rich and poor countries. Neoclassical theory has an assumption that there is free trade and there no transport cost. However, there exist transport costs and imports taxation in countries. There is also poorly developed infrastructure in poor countries, which leads to reduced capital flows. Infrastructure refers to the road network of a country, quality, and density of the transport network, access to electricity, water, and telephone. Poor countries mainly have less bitumen roads and there are inefficiencies in ports, airports and in the transport system. If there is poor roads and transport system, investors take more time to monitor their invested funds. Causa and Cohen (2004, p.33) explains that the gathering of information is also a problem in a place with no well-developed infrastructure because one has to take a long time and pass many ineffective systems such as delays in port. Access to natural materials has also made a challenge because of low infrastructure. Rose (2002, p.33) explains that some poor countries being landlocked makes them even harder to trade as one has to pass several cross national borders which have delays. Poor infrastructure also hinders competition and creates price distortions leading to a high cost of trading. Infrastructure also affects the amount of input that reaches the consumer, which hinders both international trade and domestic trade (Causa and Soto, 2006). Lack of adequate electricity in poor countries makes the cost of doing business high because of reliance on expensive generators that have high maintenance costs and periodic power blackout (Collier and Gunning, 1999). Security also influences capital flows between nations in that its absence raises the cost of doing business since firms have to provide their own security, which makes the cost act as an additional tax to the business. Securities also entail having proper protective systems of investors and their investment to prevent such activities such as illegal takeovers of their investment. This increases faith in the future of a country, which leads to more flow of capitals. Capital inflows between nations are also affected by high prevalence of conflicts in the countries. Conflicts can be either internal or external such that a country that has conflicts is instable, therefore, the level of capital flows is lower than in a country with no conflict. Countries that are riddled with domestic and external conflicts make it hard to have capital flows and contribute to capital flight (Kahl, 2006, p.36). These conflicts are in the form of ethnic wars, natural resources, political instability because of coups, elections, or militias. Countries that are in conflict with their neighbors also lead to low levels of capital flows because of a likelihood of war and delays in borders. Investors want a friendly environment that they feel secure and cannot take funds to countries with conflicts, even when returns seem high (Bhattacharya, Montiel, and Sharma, 1997). AntiLucas paradox AntiLucas paradox states that manufacturing entrepreneurs in poor countries usually substitute private capital with public ones in the case of power shortages and interruptions. The low level and quality of power generation in poor countries makes it important to provide standby generators due to unreliable electricity to run production unit (Causa and Soto, 2006). Lucas paradox can be solved through a number of ways that aim at increasing capital flows in poor countries. One involves is to reform public services, which involves developing capacity and efficiency in management of projects. This requires having competent, motivated, and corrupt-free civil service. This solves problems of corruption and political imperatives that hinder successful execution of projects that would lead to higher social returns (Tanzi and Davoodi, 1998). This would also involve inclusion of the private sector. Government should also put borrowed funds in best investment options, which yield higher returns and ensure they have the capacity to repay the loans. They should also put into place an effective tax system that is cost effective, seal tax evasion loopholes, and make revenues simpler to collect or pay. Lucas paradox can also be solved through improvement of infrastructure in poor countries (Kinda, 2010). This encourages foreign direct investment and open up remote places through the transport network. Improvement in road, railway, and airport can help to reduce the cost of doing business and make the country viable for investors, which in turn lead to increased flow of capital (Martin and Rogers, 1995). Efficiency in border points, airports, and ports can help avoid unnecessary delays and barriers that discourage trade. Availability of reliable electricity reduces reliance on expensive generators leads to a reduction in cost of power increasing profitability. Investments in power generation also increase opportunities available for investing. A country cannot have investors unless their security is assured. Poor countries in crime and conflict prone areas can make an investment in their security system to ensure that businesspeople and investors are safe. This helps reduce uncertainties and avoid disruptions in capital flows. Creation of an enabling environment in which financial intermediaries operate effectively without being directed, but allowing the ‘free hand’ to guide the financial system. These include formulation of policies that make it easy to access information, contract enforcement, efficient legal system, and policies that reduce risks. Easier access to information leads to lower information costs and thereby allow more capital flow due to investors having more knowledge about opportunities available in the country. In addition, reduction in excessive taxation to customers and financial institutions make access to funds easier and cheaper. This is because taxes are expenses to capital flows and lead to lower profitability. A country that establishes fair taxes to investors invites capital flows. This can also be achieved by provision of incentives that encourage foreign direct investment such as tax holidays. Respect and well-established property rights reduce cost of accessing legal action. Creation of a sound and stable macroeconomic environment helps to reduce cost of doing business. Improvements in healthcare and reduction in civil conflicts can have a big impact on the welfare of citizens in poor countries. This helps to attract foreign direct investments and unlock the financial ability of people through funding. Healthy people lead to more productivity. To curb diseases such as AIDS helps to improve productivity of citizens, which in turn lead to productivity. Clemens (2002) explains that education improvement also plays a big part in the welfare of citizens because an informed people attract more opportunities for investors. Education will involve integration of both theory and practical work to enhance their ability to do more work and gain more skills. An educated population also reduces the amount of time required to train in case of employment by new businesses and reduces costs significantly. In conclusion, Lucas paradox attempts to explain the reasons why capital flows between rich and poor countries is low despite the neoclassical theory, which suggested that capital flows from capital surplus areas to capital deficit areas to make higher returns. Lucas explains by use of three reasons, which include differences in human capital, external benefits of human capital and capital market imperfections. He says that individuals in poor countries have lower per capital income compared to individuals in rich countries. This difference in human capital makes it hard to invest in poor countries. Further, he asserts that there are factors in rich countries that a person has that lacks in poor countries such as level of educations and better health. He explains external benefits of human capital as a factor that results from technology. Poor countries have lower adoption and usage of technology, therefore, they are less innovative compared to rich countries limiting flow of capital. In addition, he explains that though neoclassical theory shows that there are higher returns in poor countries because of lower levels of capital, it is not the case because of factors such as market imperfections. Examples of market imperfections include failure to honor loan agreements of a country. Lucas paradox can further be explained by poorly developed infrastructure in poor countries, corrupt and ineffective public service, conflicts, and wars among countries, access to finances, sovereign risk, and government policies. Bibliography Alfaro, L., Kalemli-Ozcan, S., and Volosovych, V. (2007). Capital flows in a globalized world: The role of policies and institutions. In Capital Controls and Capital Flows in Emerging Economies: Policies, Practices and Consequences (pp. 19-72). University of Chicago Press. Alfaro, L., Kalemli-Ozcan, S., and Volosovych, V. (2008). Why doesnt capital flow from rich to poor countries? 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