Penn effect

The Penn effect is the

finding that commodity prices are higher in countries with higher income.

This is often interpreted to mean that real

result since at least the 1950s.

However, the "Penn effect", even as Samuelson used it, refers to the general observation: there is correlation between higher price levels and higher per capita income.

The Balassa-Samuelson effect model arises from a project to confirm the result and explicate the cause within the neoclassical framework.

History

Classical economics made simple predictions about exchange rates; it was said that a basket of goods would cost roughly the same amount everywhere in the world, when paid for in some common currency (like gold)¹. This is called the purchasing power parity (PPP) hypothesis, also expressed as saying that the real exchange rate (RER) between goods in various countries should be close to one. Fluctuations over time were expected by this theory but were predicted to be small and non-systematic.

Pre-1940, the PPP hypothesis found

), when compared at market exchange rates.

In 1964 the modern theoretical interpretation was set down as the Balassa–Samuelson effect, with studies since then consistently confirming the original Penn effect. However, subsequent analysis has provided many other mechanisms through which the Penn effect can arise, and historical cases where it is expected, but not found. Up until 1994 the PPP-deviation tended to be known as the "Balassa-Samuelson effect", but in his review of progress “Facets of Balassa-Samuelson Thirty Years Later" Paul Samuelson acknowledged the debt that his theory owed to the Penn World Tables data-gatherers, by coining the term “Penn effect” to describe the “basic fact” they uncovered, when he wrote:

"The Penn effect is an important phenomenon of actual history, but not an inevitable fact of life.”

Understanding the Penn effect

Most things are cheaper in poor (low income) countries than in rich ones. Someone from a "

for those two local currencies, despite the fact the two products are essentially the same.

The effect's challenge to simple open economy models

The (naïve form of the) purchasing power parity hypothesis argues that the Balassa–Samuelson effect should not occur. A simple open economy model treating Big Macs as commodity goods implies that international price competition will force Norwegian, Egyptian, and U.S. burger prices to converge in price. The Penn effect, however, maintains that the general price level will remain consistently higher where (dollar) incomes are high.

How identical products can be sold at consistently different prices in different places

The

common market from the fact that prices for the same good are different.

If a McDonald's patron in Oslo were able to eat in an identical Cairo restaurant at one quarter the price they would do so, and price competition would then equalize the Big Mac price throughout the world. Of course, someone can only eat out locally, so regional price differentials can persist; the Oslo and Cairo branches are not in competition. If the Cairo McDonald's starts giving away burgers the price in Oslo will be unaffected, since one is unlikely to dine in Cairo if starting the evening in Oslo, nor can one import an Egyptian meal into Norway by ordering take-out.

The price level

Measuring 'the' price level involves looking at goods other than burgers, but most goods in a consumer price index (CPI) show the same pattern; equivalent things tend to cost more in high income countries. Most services, perishable goods like the Big Mac, and housing cannot be purchased very far from the point of consumption (where the consumer happens to live). These items form the typical consumer shopping list, and therefore the consumer price level can vary from country to country, just like the burger price.

The international development implications

The deviation in

, a small proportion of consumption.

If the genuine income differential (taking local prices into account) is exaggerated by the market exchange rate, so the real difference in the standard of living between rich and poor countries is less than GDP per capita figures would suggest, if converted at market exchange rates. To make a more significant comparison, economists divide a country's average income by its consumer price index.

See also

• The Economist's Big Mac Index consistently shows fourfold differentials in the burger's price.
• Purchasing Power Parity
  is the situation in which RERs are 1, a nil Penn effect.

Footnotes

era of gold convertibility).

References

• Paul A. Samuelson (1994). "Facets of Balassa-Samuelson Thirty Years Later," Review of International Economics 2(3), pp. 201–26. (Abstract defining the Penn effect). (This issue has several papers discussing the effect.)

External links

• 2004 Econometric study of the effect's rise since circa 1950 (their time series starts 1500 AD, with the Penn effect only noticeable 450 years into the data). The appendix contains a thorough (eight page) two country
  General equilibrium derivation of the effect's size based on the BS hypothesis across a continuum of industries, endogenously split between traded and non-traded production. However, the paper as a whole is focused on analysis of historical economic data
  .
• G-20 ICP: An analysis of the data in the International Comparison Program gives clear Penn effect examples
• Long Run Purchasing Power Parity: Cassel or Balassa-Samuelson? - A direct 2003 comparison of Cassel's pure PPP-hypothesis and the Penn effect deviation at scales estimated by the BS-hypothesis (using data from sixteen industrialized countries). Surprisingly, this University of Houston study finds that industrialized countries tend to fit Cassel's hypothesis better (at a ratio of 2 countries to 1). This result can occur (despite an apparently clear correlation of income to price) because of the long reversion times expected by the PPP hypothesis.