Jennifer Rhee

Job market paper

The Lucas Paradox and the Return to Capital in Capital-Scarce Countries

Neoclassical theory predicts that if two countries share the same constant return to scale production function, and trade in capital goods is free and competitive, due to the law of diminishing returns (a) new investment will occur only in capital-scarce countries since (b) the marginal product of capital should be higher in economies with less capital. This statement at the heart of Lucas paradox, implicitly assumes that cross-country marginal products of capital mirror cross-country financial investment returns. Using firm-level data, I show that although firms in emerging markets enjoy higher marginal products of capital, financial investment returns are roughly equalized across developed and emerging economies. The finding questions the validity of the standard approach that uses differences in marginal products of capital to explain international capital flows. It further suggests that "there is no prima facie support for the view that international credit frictions play a major role in preventing capital flows from rich to poor countries" (Caselli and Feyrer, 2007). Finally, the paper highlights the importance of cross-country differences in capital efficiency to explain the observed patterns of financial returns.