Balassa-Samuelson effect

The Balassa-Samuelson effect is either of two related things:

The theory

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

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Summary of the empirical "Penn effect" effect to be explained

The exchange of tradable goods and services should lead prices to converge, but convergence is only partial, because some products are not tradable. (Software development is an example tradable service.)

Related Topics:
Tradable - Should - Software development

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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.

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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 Real Exchange Rate (RER) appreciates. If typical productivity gains are concentrated in tradables, high productivity will ultimately be correlated with high RER.

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In economic growth theory it is generally postulated that productivity is increasing, so the Balassa-Samuelson effect (BS-effect) is usually stated as:

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:"The traded goods sector has a higher productivity growth than the non-traded goods sector, leading to higher relative non-traded goods' prices".

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Since traded goods' relative prices are constant (at PPP), but non-traded goods' relative prices are higher, the CPI rises with average productivity growth.

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The effect in more detail

A typical discussion of this argument (e.g. by Paul Krugman) would include the following features:

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• 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 Zurich burger flipper is no more productive than his Moscow counterpart (in burger/hour) 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 (real) 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.

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 three complicating factors:

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• The econometrics of 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 movements¹ can affect the real economy and complicate the picture, a problem eliminated if comparing regions that use the same currency unit.

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 varying price differentials is that publican's 'productivity' in serving customers is more uniform (in pints per hour) than is the 'productivity' (in foreign earnings per year) of people working in the export sector in either half of the country. (Reputedly Financial services in the South of England, heavy industry in the North.) The implication that one region is less 'productive' than another is politically controversial.

Related Topics:
Pub - England - Beer - Anecdotal evidence - Price - Publican - Export - Financial services - Industry - Controversial

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