1 Inadequacy of Capital Flows from Rich to Poor Countries: The Role of Set-Up Costs Assaf Razin, Tel-Aviv University and Cornell UniversityAssaf Razin, Tel-Aviv University and Cornell University Yona Rubinstein, Tel Aviv UniversityYona Rubinstein, Tel Aviv University Efraim Sadka, Tel-Aviv UniversityEfraim 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.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.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!This is counter to evidence!

3 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? Lucas (1990) poses the question: “Why doesn’t capital flow from the rich to the poor countries?”

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

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

6 THE RRS MODEL: Investment Firm’s market value

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

8 Non-investing firm’s market value: Cut-off point which Splits to investing and non-investing firms 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, The rich country will make no new investment no new investment Equations (1) and (2) imply:

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.

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16 Descriptive Statistics Figures 1 and 1(a) describe the distribution of host/source countries by the number of source/host countries. Note: (1)No host countries get FDI flows from ALL source countries. (2)(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.

17 Fraction of Source countries by number of source countries

18 Fraction of source countries by number of host countries

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

20 Host country GDP by number of source countries

21 Source country GDP by number of source countries

22 Host country education by the number of source countries

23 Source country education by the number of source countries

24 Host country telephone lines by the number of source countries

25 Source country telephone lines by the number of source countries

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

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

28 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)

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

30 Set-up costs and selection bias:

31 Set-up costs and selection bias:

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

33 Heckman’s Selection Model

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38 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 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 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. Round 3: Replaced Trade Residuals with the actual value of Trade. Then ran the same regression as in round 1.

39 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 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 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. Round 7: Replaced the dependent variable to FDI/Equity and ran the same regression as round 2.

40 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. 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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