Penn effect Totally Explained

Everything about The Penn Effect totally explained

The Penn effect is the economic finding that real income ratios between high and low income countries are systematically exaggerated by GDP conversion at market exchange rates. It has been a consistent econometric result for at least fifty years. The "Balassa-Samuelson effect" is a model cited as the principal cause of the Penn effect by neo-classical economics, as well as being a synonym of "Penn effect".

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 Penn team documented a modern relationship: countries with higher incomes consistently had higher prices of domestically produced goods (as measured by comparable price indices), relative to prices of goods included in the exchange rate.
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's 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: ť 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, the same Big Mac cost $5.46 in Switzerland, and $1.49 in Russia in December 2004, at the prevailing USD exchange rate into the local currencies. To avoid confusion arising from money prices the nominal exchange rates are usually ignored, with only the 'real exchange rate' (RER) being considered. (Here, 3.66 Russian meals to one Swiss.)

The effect's challenge to simple open economy models

The (naïve form of the) purchasing power parity hypothesis argues that the Balassa-Samuelson effect shouldn't occur. A simple economic model treating Big Macs as commodity goods implies that international price competition will force Swiss, Russian, and U.S. burger prices to converge in price. The Penn effect denies this convergence; it's clear evidence that the general price level is much higher where (dollar) incomes are high, with no tendency to match the cheaper prices in poorer countries.

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

The law of one price says that the same item can't 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 don't share an efficient common market from the fact that prices for the same good are different.
If a McDonalds patron in Zurich were able to eat in an identical Moscow restaurant at quarter the price she'd 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 Moscow and Zurich branches are not in competition. If the Moscow McDonalds starts giving away burgers the price in Zurich will be unaffected, since one is unlikely to dine in Moscow if starting the evening in Zurich (especially if dining at McDonalds).

The price level

Measuring 'the' price level involves looking at goods other than burgers, but most goods in a 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 can't 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 CPI level can vary from country to country, just like the burger price.

The international development implications

The PPP-deviation 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 ceteris paribus, the Penn effect is a very good thing. If it didn't 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 RER, so the real difference in the standard of living between rich and poor countries is less than GDP per capita figures would suggest. To make a more significant comparison, economists divide a country's average income by its CPI.

Further Information

Get more info on 'Penn Effect'.

External Link Exchanges

Do you know how hard it is to get a link from a large encyclopaedia? Well we're different and will prove it. To get a link from us just add the following HTML to your site on a relevant page:

<a href="http://penn_effect.totallyexplained.com">Penn effect Totally Explained</a>

Then simply click through this link from your web page. Our crawlers will verify your link, extract the title of your web page and instantly add a link back to it. If you like you can remove the words Totally Explained and embed the link in article text.
As long as your link remains in place, we'll keep our link to you right here. Please play fair - our crawlers are watching. Your site must be closely related to this one's topic. Any kind of spamming, dubious practises or removing the link will result in your link from us being dropped and, potentially, your whole site being banned.