Balassa–Samuelson effect


The Balassa–Samuelson effect, also known as Harrod–Balassa–Samuelson effect, the Ricardo–Viner–Harrod–Balassa–Samuelson–Penn–Bhagwati effect, or productivity biased purchasing power parity 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 than in the non-tradable sectors.
Béla Balassa and Paul Samuelson independently proposed the causal mechanism for the Penn effect in the early 1960s.

The theory

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

The empirical “Penn Effect”

By the law of one price, entirely tradable goods cannot vary greatly in price by location. However most services must be delivered locally, and many manufactured goods such as furniture have high transportation costs, which makes deviations from one price 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 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.
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 price for tradable goods, the price of nontradable goods will be lower in the less productive country, resulting in an overall lower price level.

The effect in more detail

A typical discussion of this argument would include the following features:
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. Looking at the price level distribution within a country gives a clearer picture of the effect, because this removes three complicating factors:
  1. The econometrics of purchasing power parity tests are complicated by nominal exchange rate noise..
  2. There may be some real economy border effects between countries which limit the flow of tradables or people.
  3. Monetary effects, and exchange rate movements can affect the real economy and complicate the picture, a problem eliminated if comparing regions that use the same currency unit.
  4. 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. The BS-hypothesis explanation for the price differentials is that the 'productivity' of pub employees is more uniform than the 'productivity' of people working in the dominant tradable sector in each region of the country. 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. However, the Balassa–Samuelson hypothesis implies that countries with rapidly expanding economies should tend to have more rapidly appreciating exchange rates ; conventional econometric tests have resulted with mixed findings for the predictions of the BS effect.
In total, since it was discovered in 1964, according to Tica and Druzic 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". Also, one should have in mind that a lot of papers have been published since then. Bahmani-Oskooee and Abm and Egert, Halpern and McDonald 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 with a strong reservation against the purchasing power parity assumption in the tradable sector.
Analysis of empirical data shows that 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 or Drine & Rault analyze main BS assumptions separately:
  1. The differential of productivities between traded and non-traded sector and relative prices are positively correlated.
  2. The purchasing power parity assumption is verified for tradable goods.
  3. The RER and relative prices of non-tradable goods are positively correlated.
  4. 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:
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 imply that it produces a small effect. For instance, other effects of exchange rate movements might mask the long-term BS-hypothesis mechanism. 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:

The distribution sector

In a 2001 International Monetary Fund working 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".

The Dutch Disease

Capital inflows may stimulate currency appreciation through demand for money. As the RER appreciates, the competitiveness of the traded-goods sectors falls.
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 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%. 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'

and others say that income rises can change the ratio of demand for goods and services. 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-trade sector look relatively less productive than it had been when demand was lower; if service quality 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 between countries.

The protectionism explanation

Lipsey and Swedenborg 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 we should expect to see a correlation between rising GDP and rising prices.
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 have argued that raising International competitiveness through policies that promote traded goods sectors' productivity 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.

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, 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.