Balassa–Samuelson effect

This article includes a list of general references, but it lacks sufficient corresponding inline citations. Please help to improve this article by introducing more precise citations. (May 2022) (Learn how and when to remove this template message)

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

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

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.

${\displaystyle MPL_{nt,1}=MPL_{nt,2}=1}$

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.)

${\displaystyle w_{1}=p_{nt,1}*MPL_{nt,1}=p_{t}*MPL_{t,1}}$

${\displaystyle w_{2}=p_{nt,2}*MPL_{nt,2}=p_{t}*MPL_{t,2}}$

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

${\displaystyle MPL_{t,1}<MPL_{t,2}}$

which implies that

${\displaystyle p_{nt,1}<p_{nt,2}}$.

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.

The effect in more detail

A typical discussion of this argument 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 are less responsive to productivity innovations than others. For instance, a highly skilled Zürich burger flipper is no more productive than his Moscow counterpart (in burger/hour) but these jobs are services which must be performed locally.
• 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
  .
• To equalize local wage levels with the (highly productive) Zürich engineers, Zürich fast food employees must be paid more than Moscow fast food employees, even though the burger production rate per employee is an international constant.
• The CPI is made up of:
  • local goods (which in richer countries are more expensive relative to tradables)
  • 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 (purchasing power parity). 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

1. The
   error term
   ).
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^{[note 1]} 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. (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

In total, since it was (re)discovered in 1964, according to Tica and Druzic (2006)^[1] 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) & 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

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 & Rault (2002)) 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:

"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 & Rault conclude.

The next section lists some of the alternative proposals to an explanation of the

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 (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.^[2] 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.^{[note 2]}

Services are a 'superior good'

A shift in preferences at the

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.

The protectionism explanation

Lipsey and Swedenborg (1996) show a strong correlation between the barriers to

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^{[note 3]}

Trade theory implications

The

• List of international trade topics
• Free trade, economic inequality, and per capita income
• Mathematical economics, and econometrics

Notes