Question

Question 2: drivers of capital flows

Please explain why in theory capital should not necessarily flow from rich to poor countries.

Explain how you would distinguish between alternative theories about the lack of flows of capital from rich to poor countries

Answer 1

Under classical economic theory, capital should flow from rich country to poor countries as countries produces the same goods using same production factors under constant returns to scale. The reason for countries to be poor lies under the difference in capital per capita analogous to income per capita. But classical economic theory failed to understand other factors such as secure property right, honest government, institutional quality, better and efficient human resources, better market information etc. which are responsible for higher level of income. Whereas, poor countries lacks in more of these factors due to which market failure are more likely to happen in poor countries and in response to this, investors are less interested in investing in these countries.

In history there were lots of event which corroborate the latter theory of capital should not flow from rich to poor countries. One such event was before 1945, during that time, all third world countries were under european legal arrangements imposed through colonialism. Under which investors were bound to invest under a contract in similiar fashion as in home country and in foreign country. In spite all these investments it led to market failure.