Lucas Paradox

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

Economic theory predicts that capital should flow from rich countries to poor countries. Poor countries have lower levels of capital per worker – in part, that explains why they are poor. In poor countries, the scarcity of capital relative to labor should mean that the returns to capital are high. In response, savers in rich countries should look at poor countries as profitable places in which to invest. In reality, things just don’t 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 and is often referred to as the "Lucas Paradox."

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

1. The first group includes 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.
2. The second group of explanations focuses on international capital market imperfections, mainly sovereign risk and asymmetric information. Although capital has a high expected return in developing countries, it does not go there because of the market failures.