What is the Lucas paradox in simple terms?

Investing in poor countries that lack machines and factories should pay much higher returns, yet money tends to stay in, or flow toward, rich countries.

What is the leading explanation?

Candidates include differences in human capital, institutional quality and property rights, sovereign default risk and financial development; empirical work often finds institutional quality especially important.

Lucas Paradox

📈 Economics By CampusDown Wiki Editorial Team Last updated October 27, 2026

The Lucas paradox is the observation that, although neoclassical theory implies a much higher marginal product of capital in capital-scarce developing countries and therefore large flows of capital from rich to poor nations, actual flows are small or even reversed. Robert Lucas posed it in 1990.

Contents

1. Lucas's calculation
2. Main explanations
3. The allocation puzzle and historical comparison
4. FAQ
5. References

Lucas's calculation

Lucas (1990) applied a neoclassical production function to the United States and India in 1988. If the two countries, whose output per worker differed by a factor of about 15, shared the same technology, the marginal product of capital in India would have to be about 58 times that in the United States. All new investment should then flow to India, which was plainly not happening. Lucas proposed differences in human capital, human capital externalities, and political risk and capital market imperfections as candidate explanations.

Main explanations

Including human capital in the production function, as Mankiw, Romer and Weil (1992) did, greatly narrows the gap in marginal products. Caselli and Feyrer (2007) estimated that once the relative price of capital goods and the share of natural resources are taken into account, marginal products of capital are far more similar across countries than they appear. Alfaro, Kalemli-Ozcan and Volosovych (2008) found in data for 1970–2000 that institutional quality was the most important explanatory variable. Reinhart and Rogoff (2004) argued that histories of serial sovereign default deter capital inflows to poor countries.

The allocation puzzle and historical comparison

Gourinchas and Jeanne (2013) documented an allocation puzzle: among developing countries, those with faster productivity growth tend to export more capital on net. Prasad, Rajan and Subramanian (2007) likewise reported that developing countries relying less on foreign capital grew faster. Mendoza, Quadrini and Ríos-Rull (2009) argued that differences in financial development can explain why capital flows toward rich countries. Historically, Clemens and Williamson (2004) showed that British overseas investment in 1870–1913 also concentrated in regions rich in human capital and natural resources.

FAQ

What is the Lucas paradox in simple terms?: Investing in poor countries that lack machines and factories should pay much higher returns, yet money tends to stay in, or flow toward, rich countries.
What is the leading explanation?: Candidates include differences in human capital, institutional quality and property rights, sovereign default risk and financial development; empirical work often finds institutional quality especially important.

Sources reviewed: 2026-10-26

References

Lucas, R. E., Jr. (1990). Why doesn't capital flow from rich to poor countries? American Economic Review, 80(2), 92–96.
Alfaro, L., Kalemli-Ozcan, S., & Volosovych, V. (2008). Why doesn't capital flow from rich to poor countries? An empirical investigation. Review of Economics and Statistics, 90(2), 347–368.
Reinhart, C. M., & Rogoff, K. S. (2004). Serial default and the "paradox" of rich-to-poor capital flows. American Economic Review, 94(2), 53–58.
Gourinchas, P.-O., & Jeanne, O. (2013). Capital flows to developing countries: The allocation puzzle. Review of Economic Studies, 80(4), 1484–1515.
Prasad, E. S., Rajan, R. G., & Subramanian, A. (2007). Foreign capital and economic growth. Brookings Papers on Economic Activity, 2007(1), 153–230.
Caselli, F., & Feyrer, J. (2007). The marginal product of capital. Quarterly Journal of Economics, 122(2), 535–568.
Mankiw, N. G., Romer, D., & Weil, D. N. (1992). A contribution to the empirics of economic growth. Quarterly Journal of Economics, 107(2), 407–437.
Kraay, A., Loayza, N., Servén, L., & Ventura, J. (2005). Country portfolios. Journal of the European Economic Association, 3(4), 914–945.
Clemens, M. A., & Williamson, J. G. (2004). Wealth bias in the first global capital market boom, 1870–1913. Economic Journal, 114(495), 304–337.
Obstfeld, M., & Taylor, A. M. (2004). Global Capital Markets: Integration, Crisis, and Growth. Cambridge: Cambridge University Press.
Lane, P. R., & Milesi-Ferretti, G. M. (2007). The external wealth of nations mark II. Journal of International Economics, 73(2), 223–250.
Mendoza, E. G., Quadrini, V., & Ríos-Rull, J.-V. (2009). Financial integration, financial development, and global imbalances. Journal of Political Economy, 117(3), 371–416.
Kalemli-Ozcan, S., Reshef, A., Sørensen, B. E., & Yosha, O. (2010). Why does capital flow to rich states? Review of Economics and Statistics, 92(4), 769–783.

Reports and materials that use this theory (Korean)

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This article was last updated on October 27, 2026. It is based on widely recognized original works and textbooks; when citing it in a paper, please check the original sources listed in the references.