The Balassa–Samuelson effect, also known as Harrod–Balassa–Samuelson effect (Kravis and Lipsey 1983), the Ricardo–Viner–Harrod–Balassa–Samuelson–Penn–Bhagwati effect (Samuelson 1994, p. 201), or productivity biased
purchasing power parity (PPP) (Officer 1976) is the tendency for
consumer prices to be systematically higher in more
developed countries
A developed country (or industrialized country, high-income country, more economically developed country (MEDC), advanced country) is a sovereign state that has a high quality of life, developed economy and advanced technological infrastruct ...
than in
less developed countries
A developing country is a sovereign state with a lesser developed industrial base and a lower Human Development Index (HDI) relative to other countries. However, this definition is not universally agreed upon. There is also no clear agreem ...
. This observation about the systematic differences in consumer prices is called the "
Penn effect
The Penn effect is the economic finding that real income ratios between high and low income countries are systematically exaggerated by gross domestic product (GDP) conversion at market exchange rates. It is associated with what became the Penn Wo ...
". The Balassa–Samuelson hypothesis is the proposition that this can be explained by the greater variation in
productivity
Productivity is the efficiency of production of goods or services expressed by some measure. Measurements of productivity are often expressed as a ratio of an aggregate output to a single input or an aggregate input used in a production proces ...
between developed and less developed countries in the traded goods' sectors which in turn affects wages and prices in the non-tradable goods sectors.
Béla Balassa and
Paul Samuelson
Paul Anthony Samuelson (May 15, 1915 – December 13, 2009) was an American economist who was the first American to win the Nobel Memorial Prize in Economic Sciences. When awarding the prize in 1970, the Swedish Royal Academies stated that he " ...
independently proposed the causal mechanism for the Penn effect in the early 1960s.
The theory
The Balassa–Samuelson effect depends on inter-country differences in the relative
productivity
Productivity is the efficiency of production of goods or services expressed by some measure. Measurements of productivity are often expressed as a ratio of an aggregate output to a single input or an aggregate input used in a production proces ...
of the tradable and non-tradable sectors.
The empirical “Penn Effect”
By the
law of one price
The law of one price (LOOP) states that in the absence of trade frictions (such as transport costs and tariffs), and under conditions of free competition and price flexibility (where no individual sellers or buyers have power to manipulate prices ...
, entirely
tradable
Tradability is the property of a good or service that can be sold in another location distant from where it was produced. A good that is not tradable is called non-tradable. Different goods have differing levels of tradability: the higher the co ...
goods cannot vary greatly in price by location (because buyers can
source from the lowest cost location). However most
services must be delivered locally (e.g.
hairdressing
A hairdresser is a person whose occupation is to cut or style hair in order to change or maintain a person's image. This is achieved using a combination of hair coloring, haircutting, and hair texturing techniques. A Hairdresser may also be ref ...
), and many manufactured goods such as furniture have high transportation costs (or, conversely, low value-to-weight or low value-to-bulk ratios), which makes deviations from one price (known as
purchasing power parity or PPP-deviations) persistent. The Penn effect is that PPP-deviations usually occur in the same direction: where incomes are high,
average price levels are typically high.
Basic form of the effect
The simplest model which generates a Balassa–Samuelson effect has two countries, two goods (one tradable, and a country specific nontradable) and one factor of production, labor. For simplicity assume that productivity, as measured by marginal product (in terms of goods produced) of labor, in the nontradable sector is equal between countries and normalized to one.
where "nt" denotes the nontradable sector and 1 and 2 indexes the two countries.
In each country, under the assumption of competition in the labor market the wage ends up being equal to the value of the marginal product, or the sector's price times MPL. (Note that this is not necessary, just sufficient, to produce the Penn effect. What is needed is that wages are at least related to productivity.)
Where the subscript "t" denotes the tradables sector. Note that the lack of a country specific subscript on the price of tradables means that tradable goods prices are equalized between the two countries.
Suppose that country 2 is the more productive, and hence, the wealthier one. This means that