Tendency for consumer prices to be systematically higher in more developed countries
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.
formula_1
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.)
formula_2
formula_3
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
formula_4
which implies that
formula_5.
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:
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:
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) &amp; 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 &amp; Rault (2002)) analyze main BS assumptions separately:
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 &amp; 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.
Most professional economists accept that the Balassa–Samuelson effect model has some merit. However other sources of the Penn effect RER/GDP relationship have been proposed:
Distribution sector.
In a 2001 International Monetary Fund working paper Macdonald &amp; Ricci accept that relative productivity changes produce PPP-deviations, but argue that this is not confined to tradables versus non-tradable sectors. Quoting the abstract:An increase in the productivity and competitiveness of the distribution sector with respect to foreign countries leads to an appreciation of the real exchange rate, similarly to what a relative increase in the domestic productivity of tradables does.
Dutch Disease.
Capital inflows (say to the Netherlands) may stimulate currency appreciation through demand for money. As the RER appreciates, the competitiveness of the traded-goods sectors falls (in terms of the international price of traded goods).
In this model, there has been no change in real economy productivities, but money price productivity in traded goods has been exogenously lowered through currency appreciation. Since capital inflow is associated with high-income states (e.g. Monaco) this could explain part of the RER/Income correlation.
Yves Bourdet and Hans Falck have studied the effect of Cape Verde remittances on the traded-goods sector. They find that, as local incomes have risen with a doubling of remittances from abroad, the Cape Verde RER has appreciated 14% (during the 1990s). The export sector of the Cape Verde economy suffered a similar fall in productivity during the same period, which was caused entirely by capital flows and not by the BS-effect.
Services are a 'superior good'.
Rudi Dornbusch (1998) and others say that income rises can change the ratio of demand for goods and services (tradable and non-tradable sectors). This is because services tend to be superior goods, which are consumed proportionately more heavily at higher incomes.
A shift in preferences at the microeconomic level, caused by an income effect can change the make-up of the consumer price index to include proportionately more expenditure on services. This alone may shift the consumer price index, and might make the non-traded sector look relatively less productive than it had been when demand was lower; if service quality (rather than quantity) follows diminishing returns to labour input, a general demand for a higher service quality automatically produces a reduction in per-capita productivity.
A typical labour market pattern is that high-GDP countries have a higher ratio of service-sector to traded-goods-sector employment than low-GDP countries. If the traded/non-traded consumption ratio is also correlated with the price level, the Penn effect would still be observed with labour productivity rising equally fast (in identical technologies) between countries.
Protectionism.
Lipsey and Swedenborg (1996) show a strong correlation between the barriers to free trade and the domestic price level. If wealthy countries feel more able to protect their native producers than developing nations (e.g. with tariffs on agricultural imports) we should expect to see a correlation between rising GDP and rising prices (for goods in protected industries - especially food).
This explanation is similar to the BS-effect, since an industry needing protection must be measurably less productive in the world market of the commodity it produces. However, this reasoning is slightly different from the pure BS-hypothesis, because the goods being produced are 'traded-goods', even though protectionist measures mean that they are more expensive on the domestic market than the international market, so they will not be "traded" internationally
Trade theory implications.
The supply-side economists (and others) have argued that raising international competitiveness through policies that promote traded goods sectors' productivity (at the expense of other sectors) will increase a nation's GDP, and increase its standard of living, when compared with treating the sectors equally. The Balassa–Samuelson effect might be one reason to oppose this trade theory, because it predicts that: "a GDP gain in traded goods does not lead to as much of an improvement in the living standard as an equal GDP increase in the non-traded sector". (This is due to the effect's prediction that the CPI will increase by more in the former case.)
History.
The Balassa–Samuelson effect model was developed independently in 1964 by Béla Balassa and Paul Samuelson. The effect had previously been hypothesized in the first edition of Roy Forbes Harrod's "International Economics" (1939, pp. 71–77), but this portion was not included in subsequent editions.
Partly because empirical findings have been mixed, and partly to differentiate the model from its conclusion, modern papers tend to refer to the Balassa–Samuelson "hypothesis", rather than the Balassa–Samuelson "effect". (See for instance: "A panel data analysis of the Balassa-Samuelson hypothesis", referred to above.)
Notes.
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References.
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Further reading.
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"results do not show supportive evidence for the Balassa–Samuelson effect in the long run."
"Real appreciation is also observed in tradables and often accounts for the bulk in the overall appreciation".