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 than in less developed countries. This observation about the systematic differences in consumer prices is called the "Penn effect". The Balassa–Samuelson hypothesis is the proposition that this can be explained by the greater variation in productivity 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 independently proposed the causal mechanism for the Penn effect in the early 1960s.
Theory The Balassa–Samuelson effect depends on inter-country differences in the relative productivity of the tradable and non-tradable sectors.
Empirical "Penn Effect" By the law of one price, entirely tradable 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), 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 the law of 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
which implies that
.
So with a same (world) price for tradable goods, the price of nontradable goods will be lower in the less productive country, resulting in an overall lower price level.
Details A typical discussion of this argument would include the following features: Workers in some countries have higher productivity than in others. This is the ultimate source of the income differential. (Also expressed as productivity growth.) Certain labour-intensive jobs are less responsive to productivity innovations than others. For instance, a highly skilled Zürich burger flipper is no more productive than his Moscow counterpart (in burger/hour) but these jobs are services which must be performed locally. The fixed-productivity sectors are also the ones producing non-transportable goods (for instance haircuts) – this must be the case or the labour intensive work would have been off-shored. To equalize local wage levels with the (highly productive) Zürich engineers, Zürich fast food employees must be paid more than Moscow fast food employees, even though the burger production rate per employee is an international constant. The CPI is made up of: local goods (which in richer countries are more expensive relative to tradables), and tradables, which have the same price everywhere The (real) exchange rate is pegged (by the law of one price) so that tradable goods follow PPP (purchasing power parity). The assumption that PPP holds only for tradable goods is testable. Since money exchange rates will vary fully with tradable goods productivity, but average productivity varies to a lesser extent, the (real goods) productivity differential is less than the productivity differential in money terms. Productivity becomes income, so the real income varies less than the money income does. This is equivalent to saying that the money exchange rate exaggerates the real income, or that the price level is higher in more productive, richer, economies.
Equivalent Balassa–Samuelson effect within a country The average asking price for a house in a prosperous city can be ten times that of an identical house in a depressed area of the same country. Therefore, the RER-deviation exists independent of what happens to the nominal exchange rate (which is always 1 for areas sharing the same currency). Looking at the price level distribution within a country gives a clearer picture of the effect, because this removes some complicating factors: The econometrics of purchasing power parity (PPP) tests are complicated by nominal exchange rate noise. (This noise would be an econometric problem, even assuming that the exchange rate volatility is a pure error term). There may be some real economy border effects between countries which limit the flow of tradables or people. Monetary effects, and exchange rate movementsThere may be a causal link from exchange rates to productivity, as well as (or instead of) the opposite direction of causation (from productivity to RERs) given by the BS-hypothesis model. Michael E. Porter's The Competitive Advantage of Nations says that currency depreciations can reduce growth, and that 'overvalued' currencies can contribute to domestic productivity growth by 'forcing' efficiency improvements in the tradables sector (by exposing it to international competition at unfavourable terms of trade). In fact, Singapore gave "Competitive Appreciation" as the official reason for the high SGD policy. (Lu & Yu 1999). Other mechanisms through which RERs can affect productivity growth have been advanced, such as the idea that structural transitions caused by exchange rate volatility have a disruptive effect on the real economy. There is some econometric evidence that the causality from exchange rates to productivity is more significant than the reverse, i.e. the BS-effect. (For instance, .) can affect the real economy and complicate the picture, a problem eliminated if comparing regions that use the same currency unit. Taxes are very different in many countries, whereas in a same country taxes are usually equal or similar.
A pint of pub beer is famously more expensive in the south of England than the north, but supermarket beer prices are very similar. This may be treated as anecdotal evidence in favour of the Balassa–Samuelson hypothesis, since supermarket beer is an easily transportable, traded good. (Although pub beer is transportable, the pub itself is not.) The BS-hypothesis explanation for the price differentials is that the 'productivity' of pub employees (in pints served per hour) is more uniform than the 'productivity' (in foreign currency earned per year) of people working in the dominant tradable sector in each region of the country (financial services in the south of England, manufacturing in the north). Although the employees of southern pubs are not significantly more productive than their counterparts in the north, southern pubs must pay wages comparable to those offered by other southern firms in order to keep their staff. This results in southern pubs incurring a higher labour cost per pint served.
Empirical evidence on the Balassa–Samuelson effect Evidence for the Penn effect is well established in today's world (and is readily observable when traveling internationally). However, the Balassa–Samuelson (BS) hypothesis implies that countries with rapidly expanding economies should tend to have more rapidly appreciating exchange rates (for instance the Four Asian Tigers); conventional econometric tests yield mixed findings for this prediction.
In total, since it was (re)discovered in 1964, according to Tica and Druzic (2006) the HBS theory "has been tested 60 times in 98 countries in time series or panel analyses and in 142 countries in cross-country analyses. In these analyzed estimates, country specific HBS coefficients have been estimated 166 times in total, and at least once for 65 different countries". Many papers have been published since then. Bahmani-Oskooee and Abm (2005) & Egert, Halpern and McDonald (2006) also provide quite interesting surveys of empirical evidence on BS effect.
Over time, the testing of the HBS model has evolved quite dramatically. Panel data and time series techniques have crowded out old cross-section tests, demand side and terms of trade variables have emerged as explanatory variables, new econometric methodologies have replaced old ones, and recent improvements with endogenous tradability have provided direction for future researchers.
The sector approach combined with panel data analysis and/or cointegration has become a benchmark for empirical tests. Consensus has been reached on the testing of internal and external HBS effects (vis a vis a numeraire country) with a strong reservation against the purchasing power parity assumption in the tradable sector.
The vast majority of the evidence supports the HBS model. A deeper analysis of the empirical evidence shows that the strength of the results is strongly influenced by the nature of the tests and set of countries analyzed. Almost all cross-section tests confirm the model, while panel data results confirm the model for the majority of countries included in the tests. Although some negative results have been returned, there has been strong support for the predictions of a cointegration between relative productivity and relative prices within a country and between countries, while the interpretation of evidence for cointegration between real exchange rate and relative productivity has been much more controversial.
Therefore, most of the contemporary authors (e.g.: Egert, Halpern and McDonald (2006); Drine & Rault (2002)) analyze main BS assumptions separately: The differential of productivities between the traded and non-traded sector and relative prices are positively correlated. The purchasing power parity assumption is verified for tradable goods. The RER and relative prices of non-tradable goods are positively correlated. As a consequence of 1, 2, & 3, there is a long-run relationship between productivity differentials and the RER.
Refinements to the econometric techniques and debate about alternative models are continuing in the International economics community. For instance: "A possible explanation of the BS empirical rejection may simply be that there are additional long-run real exchange determinants that have to be considered." Drine & Rault conclude.
The next section lists some of the alternative proposals to an explanation of the Penn effect, but there are significant econometric problems with testing the BS-hypothesis, and the lack of strong evidence for it between modern economies may not refute it, or even imply that it produces a small effect. For instance, other effects of exchange rate movements might mask the long-term BS-hypothesis mechanism (making it harder to detect if it exists). Exchange rate movements are believed by some to affect productivity; if this is true then regressing RER movements on differential productivity growth will be 'polluted' by a totally different relationship between the variables1.
Alternative, and additional causes of the Penn effect