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The Lucas Paradox

In economics, the Lucas paradox or the Lucas puzzle is the observation that capital does not flow from developed countries to developing countries despite the fact that developing countries have lower levels of capital per worker.

Classical economic theory predicts that capital should flow from rich countries to poor countries, due to the effect of diminishing returns of capital. Poor countries have lower levels of capital per worker – which explains, in part, why they are poor. In poor countries, the scarcity of capital relative to labor should mean that the returns related to the infusion of capital are higher than in developed countries. In response, savers in rich countries should look at poor countries as profitable places in which to invest. In reality, things do not seem to work that way. Surprisingly little capital flows from rich countries to poor countries. This puzzle, famously discussed in a paper by Robert Lucas in 1990, is often referred to as the «Lucas Paradox.»

The theoretical explanations for the Lucas Paradox can be grouped into two categories.

The first group attributes the limited amount of capital received by poorer nations to differences in fundamentals that affect the production structure of the economy, such as technological differences, missing factors of production, government policies, and the institutional structure.
The second group of explanations focuses on international capital market imperfections, mainly sovereign risk (risk of nationalization) and asymmetric information. Although the expected return on investment might be high in many developing countries, it does not flow there because of the high level of uncertainty associated with those expected returns.