Penn effect

Last updated October 15, 2023

The Penn effect is the economic finding that real income ratios between high and low income countries are systematically exaggerated by gross domestic product (GDP) conversion at market exchange rates. It is associated with what became the Penn World Table, and it has been a consistent econometric result since at least the 1950s.

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 econometric support, but some time after the Second World War, a series of studies by a University of Pennsylvania team documented a modern relationship: countries with higher incomes consistently had higher prices of domestically produced goods (as measured by comparable price indices), 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 "first world" country on vacation in a "third world" country will usually find their money going a lot further abroad than at home. For instance, a Big Mac cost $7.84 in Norway and $2.39 in Egypt in January 2013, at the prevailing USD exchange rate 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 law of one price says that the same item cannot sustain two different sale prices in the same market (since everyone would buy only at the lower price). By reversing this law, we can infer that different countries do not share an efficient 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 Purchasing power parity allows rural Indians to survive on an income below the absolute subsistence level in the rich world. If the money income levels are taken as given, then all else being equal, the Penn effect is a very good thing. If it did not apply, millions of the world's poorest people would find that their income was below the survival threshold. However, the effect implies that the money income level disparity as measured by international exchange rates is an illusion, because these exchange rates only apply to traded goods, 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.

Footnotes

¹ For instance, economists in 1949 expected that one could buy similar quantities of meat in New York for one dollar as in Tokyo for 360 Yen, the pegged nominal exchange rate at the time. It was thought that deviations from this would mostly be caused by problems of supply, and the fact that exchange rates were not allowed to float to market levels by most of the world's central banks (before the 1970s and the end of the Bretton Woods era of gold convertibility).

Related Research Articles

Purchasing power parity (PPP) is a measure of the price of specific goods in different countries and is used to compare the absolute purchasing power of the countries' currencies. PPP is effectively the ratio of the price of a basket of goods at one location divided by the price of the basket of goods at a different location. The PPP inflation and exchange rate may differ from the market exchange rate because of tariffs, and other transaction costs.

This aims to be a complete article list of economics topics:

In finance, an exchange rate is the rate at which one currency will be exchanged for another currency. Currencies are most commonly national currencies, but may be sub-national as in the case of Hong Kong or supra-national as in the case of the euro.

The Big Mac Index is a price index published since 1986 by The Economist as an informal way of measuring the purchasing power parity (PPP) between two currencies and providing a test of the extent to which market exchange rates result in goods costing the same in different countries. It "seeks to make exchange-rate theory a bit more digestible." The index compares the relative price worldwide to purchase the Big Mac, a hamburger sold at McDonald's restaurants.

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 (PPP) 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 which in turn affects wages and prices in the non-tradable goods sectors.

The Heckscher–Ohlin model is a general equilibrium mathematical model of international trade, developed by Eli Heckscher and Bertil Ohlin at the Stockholm School of Economics. It builds on David Ricardo's theory of comparative advantage by predicting patterns of commerce and production based on the factor endowments of a trading region. The model essentially says that countries export the products which use their relatively abundant and cheap factors of production, and import the products which use the countries' relatively scarce factors.

The law of one price (LOOP) states that in the absence of trade frictions, and under conditions of free competition and price flexibility, identical goods sold in different locations must sell for the same price when prices are expressed in a common currency. This law is derived from the assumption of the inevitable elimination of all arbitrage.

The overshooting model, or the exchange rate overshoot hypothesis, first developed by economist Rudi Dornbusch, is a theoretical explanation for high levels of exchange rate volatility. The key features of the model include the assumptions that goods' prices are sticky, or slow to change, in the short run, but the prices of currencies are flexible, that arbitrage in asset markets holds, via the uncovered interest parity equation, and that expectations of exchange rate changes are "consistent": that is, rational. The most important insight of the model is that adjustment lags in some parts of the economy can induce compensating volatility in others; specifically, when an exogenous variable changes, the short-term effect on the exchange rate can be greater than the long-run effect, so in the short term, the exchange rate overshoots its new equilibrium long-term value.

The international dollar, also known as Geary–Khamis dollar, is a hypothetical unit of currency that has the same purchasing power parity that the U.S. dollar had in the United States at a given point in time. It is mainly used in economics and financial statistics for various purposes, most notably to determine and compare the purchasing power parity and gross domestic product of various countries and markets. The year 1990 or 2000 is often used as a benchmark year for comparisons that run through time. The unit is often abbreviated, e.g. 2000 US dollars or 2000 International$.

<span class="mw-page-title-main">Outline of economics</span> Overview of and topical guide to economics

The following outline is provided as an overview of and topical guide to economics:

Relative Purchasing Power Parity is an economic theory which predicts a relationship between the inflation rates of two countries over a specified period and the movement in the exchange rate between their two currencies over the same period. It is a dynamic version of the absolute purchasing power parity theory.

The Penn World Table (PWT) is a set of national-accounts data developed and maintained by scholars at the University of California, Davis and the Groningen Growth Development Centre of the University of Groningen to measure real GDP across countries and over time. Successive updates have added countries, years (1950-2019), and data on capital, productivity, employment and population. The current version of the database, version 10, thus allows for comparisons of relative GDP per capita, as a measure of standard of living, the productive capacity of economies and their productivity level. Compared to other databases, such as the World Bank's World Development Indicators, the time period covered is larger and there is more data that is useful for comparing productivity across countries and over time.

This glossary of economics is a list of definitions of terms and concepts used in economics, its sub-disciplines, and related fields.

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.

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