The Paradox of Rich-to-Poor Capital Flow Essay -- North-South Capital

According to the Solow Growth Model, all countries will eventually converge to their long run steady state. If we consider the usual assumptions, of countries producing the same goods with the same constant returns to scale production technology, using (homogenous) capital and labour as factors of production, differences in income per capita income will reflect differences in per capita capital. Therefore, essentially if capital is allowed to flow freely, new investments should occur only in the poorer economy. However this is certainly not the case in reality. Most of the net capital flow in the past four decades has been north-to-north (rich countries investing in other rich countries), rather than north-south (rich economies investing in poorer ones) as predicted by the Solow Growth Model. Lucas (1990) compares the USA and India using data from 1988 to show that capital does not flow from rich to poor countries as predicted by the neoclassical growth model, and in setting out his simple framework he illustrates the paradox that exists. Assuming a production function y = Ax^B, the relative marginal productivity of capital (MPK) will be given by- rIndia/ rUS= (yIndia / yUS)^(ÃŽ ² -1)/ ÃŽ ². Plugging the data from 1988 in, we find that the marginal product of India should be 58 times that of the USA, as a result of which all investment should flow from the US to India. This is where the paradox lies-in reality such flows are not observed. The law of diminishing returns implies that the marginal productivity of capital will be higher in poorer countries. If this model is correct, and the capital markets are free and complete, investment should take place in India and other poor countries, and not in the USA or other richer countres... ...11. 3. Michael A. Clemens. (2002). Do Rich Countries InvestLess in Poor Countries thanthe Poor Countries Themselves?†. Available: www.jstor.com. Last accessed 20th Jan 2011. 4. Jonathan Eaton Mark Gersovitz Joseph E. Stiglitz. (1986). THE PURE THOERY OF COUNTRY RISK. Available: http://www.nber.org/papers/w1894.pdf. Last accessed 20th Jan 2011. 5. Wei, Shang-Jin. (2000). Local Corruption and Global Capital FlowsComment and Discussion. Available: www.jstor.com. Last accessed 20th Jan 2011. 6. Ays ¸e Y. Evrensel. (2004). Lending to developing countries revisited: changing nature of lenders and payment problems. Available: http://www.sciencedirect.com/science?_ob=MImg&_imagekey=B6W8Y-4DS906V-1-1&_cdi=6667&_user=128590&_pii=S0939362504000615&_origin=search&_coverDate=09/01/2004&_sk=999719996&view=c&wchp=dGLbVzW-zSkWA&md5. Last accessed 20th Jan 2011. 7. Lecture Notes