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Inadequacy of Capital Flows from Rich to Poor Countries: The Role of Set-Up Costs

This study examines the reasons behind the limited capital flows from rich to poor countries, focusing on the impact of labor mobility barriers and set-up costs. The findings suggest that administrative restrictions and high set-up costs hinder the movement of labor and investments, resulting in inadequate capital flows.

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Inadequacy of Capital Flows from Rich to Poor Countries: The Role of Set-Up Costs

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  1. Inadequacy of Capital Flows from Rich to Poor Countries: The Role of Set-Up Costs • Assaf Razin, Tel-Aviv University and Cornell University • Yona Rubinstein, Tel Aviv University • Efraim Sadka, Tel-Aviv University

  2. The law of diminishing returns implies that the marginal product of capital is high in poor countries and low in rich countries. • With a neoclassical constant-returns-to-scale production function, capital will move, from the rich to the poor countries, up to the point where capital-labor ratios are equalized across countries. At the equilibrium, labor is not going to move from the poor to the rich countries. • This is counter to evidence!

  3. Lucas (1990) poses the question: “Why doesn’t capital flow from the rich to the poor countries?” The meaning: There is free capital mobility from rich to poor countries but labor is administratively barred from migrating from poor to rich countries. How can these joint phenomena be explained?

  4. Lucas’ model Before capital moves: After capital moves:

  5. The Razin-Rubinstein-Sadka Model N firms -production function -productivity -CDF

  6. THE RRS MODEL: Investment Firm’s market value

  7. First-order conditions capital labor Investing firm’s capital and labor Non- Investing firm’s labor

  8. Non-investing firm’s market value: Cut-off point which Splits to investing and non-investing firms

  9. Labor-Market Equilibrium

  10. Dividing by N

  11. International Effective Wage Differentials

  12. Proof: Suppose, to the contrary, that The demand for labor in effective units is equalized across countries. But, the supply of labor is NOT equal. A contradiction.

  13. Therefore, Equations (1) and (2) imply: The rich country will make no new investment

  14. Establishing a new firm through foreign direct investments: The poor country attracts new FDI, N rises. Assume that the new-comer entrepreneurs evolve gradually over time. Eventually the dynamic process will end in a steady state where capital labor ratios are equalized and labor per firm is equalized.

  15. Descriptive Statistics Figures 1 and 1(a) describe the distribution of host/source countries by the number of source/host countries. Note: • No host countries get FDI flows from ALL source countries. • (2)The distribution of source countries by the number of host countries they serve is quite UNIFORM.see Fig 1(a). This suggests that it is expensive to serve many host countries for an individual source country.

  16. Fraction of Source countries by number of source countries

  17. Fraction of source countries by number of host countries

  18. Figures 2-4 demonstrate that the number of source countries that each host country gets FDI from depends ONLY on source country characteristics.

  19. Host country GDP by number of source countries

  20. Source country GDP by number of source countries

  21. Host country education by the number of source countries

  22. Source country education by the number of source countries

  23. Host country telephone lines by the number of source countries

  24. Source country telephone lines by the number of source countries

  25. FDI flows from source i to host j in period t: THE ECONOMETRIC APPROACH unobserved time-invariant term and an i.i.d shock term Latent variable, indicating profit

  26. The error term in the profit equation: Unobserved set-up costs: time dependent and time invariant components Error term Latent variable indicating profit

  27. For a random sample , the classical assumptions regarding the error term hold: Error term in equation (8) Error term in equation (10) From (9) and (11)

  28. According to the model Y is positive, if and only if Z is positive: unobserved observed

  29. Set-up costs and selection bias:

  30. Set-up costs and selection bias:

  31. Heckman’s Selection Model :Probit analysis Profit eq residual Vector of Fixed effects

  32. Heckman’s Selection Model

  33. Brief Description of Each Round Round 1: The three original tables from the paper. Gravity Equations for Trade, FDI, and Equity with trade residual not including host country creditor rights. Round 2: Regressed trade including host country creditor rights. The trade residual from this regression is then used in the regression from round 1. Round 3: Replaced Trade Residuals with the actual value of Trade. Then ran the same regression as in round 1.

  34. Round 4: Replaced the dependent variable to FDI/Trade and Equity/Trade. Then ran the same regression as Round 3. Round 5: Regressed the gravity equation for trade and using the fitted values of trade, then ran the same regression as in round 4. Round 6: The same regression as Round 4 including time dummy variables. Round 7: Replaced the dependent variable to FDI/Equity and ran the same regression as round 2.

  35. Round 8: Replaced the dependent variable with the volatility of FDI and ran the same regression as round 2. Round 9: Instrumented the host country Debt-Equity ratio with Host country GDP per capita, host country creditor rights, and host country dummies. Then ran the same regression as round 4.

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