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), productivity biased purchasing power parity
(PPP) (Officer 1976) and the rule of five eights (David 1972)) is either of two related things:
- The observation that consumer price levels in wealthier countries are systematically higher than in poorer ones (the "Penn effect").
- 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 (the Balassa-Samuelson hypothesis).
This article deals with point (2): Balassa and Samuelson's causal model. For a fuller description of the stylized fact it attempts to explain see: Penn effect.
The Balassa-Samuelson effect (BS-effect) depends on inter-country differences in the relative productivity of the tradable and non-tradable sectors.
The empirical "Penn Effect" effect
The exchange of tradable goods and services should lead prices to converge, but convergence is only partial, because some products are not tradable, and some products are generally produced locally (e.g. bread). (Software development is an example of tradable service, while a haircut is a non-tradable one.)
The Penn effect is that the RER (Real Exchange Rate) deviations usually occur in the same direction: where incomes are high, price levels, as for example measured by the Consumer Price Index are relatively high compared to an international average, and where they are low, they tend to be below the average.
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 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. 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