Balassa-Samuelson effect is used to mean two related things:

1. The observation that consumer price levels in wealthier countries are systematically higher than in poorer ones; see the Penn effect.
2. An economic model predicting the above, based on the assumption that productivity or productivity growth-rates vary more by country in the traded goods' sectors than in other sectors.

This article deals with point (2): Balassa & Samuelson's causal model. A fuller description of the stylized fact it explains is given on the Penn effect page.

History

The Balassa-Samuelson effect model was developed in 1964 by both Bela Balassa & Paul Samuelson, working independently.

The theory

The Balassa-Samuelson effect depends on inter-country differences in the relative productivity of the tradable and non-tradable sectors.

Summary of the empirical effect to be explained

The exchange of tradable goods & services should lead to price converge, but convergence is only partial, because some products are not tradable. (Software development is an example tradable service.) The interesting Penn effect is that the RER deviations usually occur in the same direction: where incomes are high, prices are relatively expensive compared to an international average, and where they are low, the CPI tends to be below the average.

Basic form of the effect

If productivity gains against foreign countries are concentrated in the tradable sector, the domestic relative price of non-tradables will increase, and as the relative average price rises the RER appreciates. If typical productivity gains are concentrated in tradables, high productivity will ultimately be correlated with high RER.

In economic growth theory it is generally postulated that productivity is increasing, so the Balassa-Samuelson effect is usually stated as: "The traded goods sector has a higher productivity growth than the non-traded goods sector, leading to higher relative non-traded goods' prices". Since traded goods' relative prices are constant (at PPP), but non-traded goods' relative prices are higher, the CPI rises with average productivity growth.

The effect in more detail

A typical discussion of this argument (e.g. by Paul Krugman) 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 cannot be performed at different productivity levels, for instance, a highly skilled Zurich burger flipper is no more productive than his Moscow counterpart, but these jobs are services which must be performed locally. *To equalize local wage levels with the (highly productive) Zurich engineers, McDonalds Zurich employees must be paid more than McDonalds Moscow employees, even though the burger production rate per employee is an international constant.
• 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 .
• The CPI is made up of:
  • local goods (which are expensive relative to tradables in rich countries)
  • Tradables, which have the same price everywhere
• The nominal exchange rate is pegged (by the law of one price) so that tradable goods follow PPP. 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.

Emperical evidence on the Balassa-Samuelson effect explanation

A worldwide study (Kravis & Lipsey, 1998) has provided evidence that non-traded goods prices do tend to rise faster than (or relative to) traded goods prices.

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 a nominal exchange rate cause. Looking at the price level distribution within a country gives a clearer picture of the effect, because this removes two complicating factors:

1. The econometrics of PPP tests are complicated by nominal exchange rate noise. (A methodology problem, assuming that the exchange rate volatility is a pure error term ).
2. There may be some real economy border effects between countries which limit the flow of tradables or people.

A pint of pub beer is famously more expensive in the south of England than the North, but supermarket beer prices are very similar. Again, evidence of the Balassa-Samuelson effect, since supermarket beer is an easily transportable, traded good. Although pub beer is transportable the pub itself is not, and nor are is costs, especially staff costs.

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 effect have been proposed:

The distribution sector

In a 2003 paper Macdonald & 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".

A demand side explanation

A completely different source of the PPP-deviation can be derived from the demand side of the economy, rather than the Balassa-Samuelson supply side model.

When any non-tradable comes up for sale its price will be determined by the relative preference between it and money by the average market consumer. By definition, high income consumers have more money, and are indifferent at a higher sale prices between buying an item and not doing so, relative to consumers in a low income area. In tradable goods, supply could shift from poor regions to rich to take advantage of this, forcing price convergence. However, non-tradable supply cannot do this, by definition. Therefore, price differences are caused (in this model) by nothing but relative differences in the abundance of money.

In this demand-side model, the initial sources of income difference are treated as given. (Income is either exogenous or evolves based on the ability to sell non-tradables at higher prices where incomes are higher.) This model leads to random walk RER behaviour, as the exogenous rich trickle their wealth down to nearby workers without requiring them to improve productivity (the rich simply bid up local service prices). Charging what the market will bear creates the PPP-deviation in a similar way to the Balassa-Samuelson effect, but doesn't explicitly rely on productivity differentials or the changes in them.

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.)

The future of the 'Balassa-Samuelson effect'

If productivity growth is declining then it may limit the size of the Balassa-Samuelson effect, as a halving of productivity growth in both tradable and non-tradable sectors would halve the relative productivity growth as well.

If the Balassa-Samuelson effect is largely responsible for the deviation from purchasing power parity it is asked why the effect's principal assumption is true; why are productivity gains faster in tradable than non-tradable sectors? It is generally assumed that the production of tradables can be automated more completely than non-tradables. (Compare car and car-washes.) In economic jargon this is expressed as: tradables manufacture is more capital intensive. However, the degree to which tradables business is capital intensive may be declining; the knowledge economy has seen the rise of tradable services, such as financial products, with headcount as the principal business expense (implying a low marginal product of capital). If the productivity difference is dependent on capital accumulation, the significance of the Balassa-Samuelson effect may decline with the economic significance of heavy machinary.

However, the market in traded goods must always be more competitive than in non-tradables, simply because it is larger. In the tradable market place all producers of a commodity are in competition with all the other producers of the same item (and similar substitutes). Non tradables must only out-compete the local rivals. If competition drives productivity growth, tradables will always have higher growth than non-tradables, and the Balassa-Samuelson effect may always be with us.

External links

• The classical explanation of the Balassa–Samuelson Effect in a mathematical form
• A widely cited examination of the relationship between distribution-sector productivity and the effect

(this is a good source of futher links to the academic Balassa-Samuelson effect discussion.)

• An Empirical test of Balassa-Samuelson from 2000 "results do not show supportive evidence for the Balassa-Samuelson effect in the long run."
• Paper disputes the applicability of the law of one price to traded goods; so that the pure Balassa-Sumuelson effect is an underestimate of likely RER changes (Cincibuch & Podpiera (2004) studied the RER appreciation to explain why it exceeds the Balassa-Samuelson prediction in the case of bilateral German-Central European country trade as the traded goods' productivity gap has declined. They argue that in practise, border barriers mean that tradables appreciate with productivity, and that "real appreciation is also observed in tradables and often accounts for the bulk in the overall appreciation".)