Penn effect
Encyclopedia
The Penn effect is the economic finding associated with what became the Penn World Table
that real income
ratios between high and low income countries are systematically exaggerated by gross domestic product
(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".
)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 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:
" 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 Russia
n meals to one Swiss.)
hypothesis argues that the Balassa-Samuelson effect shouldn't occur. A simple open economy
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 is 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.
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 McDonalds patron in Zurich
were able to eat in an identical Moscow
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 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.
(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 CPI level can vary from country to country, just like the burger price.
ns 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 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 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 consumer price index.
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 rate
s 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).
Penn World Table
The Penn World Table is a set of national-accounts data developed and maintained by scholars at the University of Pennsylvania to measure real GDP from the corresponding relative price levels across countries and over time...
that real income
Income
Income is the consumption and savings opportunity gained by an entity within a specified time frame, which is generally expressed in monetary terms. However, for households and individuals, "income is the sum of all the wages, salaries, profits, interests payments, rents and other forms of earnings...
ratios between high and low income countries are systematically exaggerated by gross domestic product
Gross domestic product
Gross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....
(GDP) conversion at market exchange rates. It has been a consistent econometric result for at least fifty years.
The "Balassa-Samuelson effect
Balassa-Samuelson effect
The Balassa–Samuelson effect, also known as Harrod–Balassa–Samuelson effect , the Ricardo–Viner–Harrod–Balassa–Samuelson–Penn–Bhagwati effect , productivity biased purchasing power parity and the rule of five eights is either of two related things:#The observation that consumer price levels...
" 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 goldGold
Gold is a chemical element with the symbol Au and an atomic number of 79. Gold is a dense, soft, shiny, malleable and ductile metal. Pure gold has a bright yellow color and luster traditionally considered attractive, which it maintains without oxidizing in air or water. Chemically, gold is a...
)1. This is called the purchasing power parity
Purchasing power parity
In economics, purchasing power parity is a condition between countries where an amount of money has the same purchasing power in different countries. The prices of the goods between the countries would only reflect the exchange rates...
(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
University of Pennsylvania
The University of Pennsylvania is a private, Ivy League university located in Philadelphia, Pennsylvania, United States. Penn is the fourth-oldest institution of higher education in the United States,Penn is the fourth-oldest using the founding dates claimed by each institution...
team documented a modern relationship: countries with higher incomes consistently had higher prices of domestically produced goods (as measured by comparable price indices
CPI
A consumer price index is a measure of the average price of consumer goods and services purchased by householdsCPI may also stand for:*Central Port Injection, see fuel injection...
), relative to prices of goods included in the exchange rate
Exchange rate
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...
.
In 1964 the modern theoretical interpretation was set down as the Balassa-Samuelson effect
Balassa-Samuelson effect
The Balassa–Samuelson effect, also known as Harrod–Balassa–Samuelson effect , the Ricardo–Viner–Harrod–Balassa–Samuelson–Penn–Bhagwati effect , productivity biased purchasing power parity and the rule of five eights is either of two related things:#The observation that consumer price levels...
, 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
Paul Samuelson
Paul Anthony Samuelson was an American economist, and the first American to win the Nobel Memorial Prize in Economic Sciences. The Swedish Royal Academies stated, when awarding the prize, that he "has done more than any other contemporary economist to raise the level of scientific analysis in...
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 worldFirst World
The concept of the First World first originated during the Cold War, where it was used to describe countries that were aligned with the United States. These countries were democratic and capitalistic. After the fall of the Soviet Union and the end of the Cold War, the term "First World" took on a...
" country on vacation in a "third world
Third World
The term Third World arose during the Cold War to define countries that remained non-aligned with either capitalism and NATO , or communism and the Soviet Union...
" country will usually find their money going a lot further abroad than at home.
For instance, the same Big Mac
Big Mac
The Big Mac is a hamburger sold by McDonald's, an international fast food restaurant chain. It is one of the company's signature products...
cost $5.46 in Switzerland
Switzerland
Switzerland name of one of the Swiss cantons. ; ; ; or ), in its full name the Swiss Confederation , is a federal republic consisting of 26 cantons, with Bern as the seat of the federal authorities. The country is situated in Western Europe,Or Central Europe depending on the definition....
, and $1.49 in Russia in December 2004, at the prevailing USD exchange rate
Exchange rate
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...
into the local currencies. To avoid confusion arising from money
Money
Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value; and, occasionally in the past,...
prices the nominal exchange rates are usually ignored, with only the 'real exchange rate' (RER) being considered. (Here, 3.66 Russia
Russia
Russia or , officially known as both Russia and the Russian Federation , is a country in northern Eurasia. It is a federal semi-presidential republic, comprising 83 federal subjects...
n meals to one Swiss.)
The effect's challenge to simple open economy models
The (naïve form of the) purchasing power parityPurchasing power parity
In economics, purchasing power parity is a condition between countries where an amount of money has the same purchasing power in different countries. The prices of the goods between the countries would only reflect the exchange rates...
hypothesis argues that the Balassa-Samuelson effect shouldn't occur. A simple open economy
Open economy
An open economy is an economy in which there are economic activities between domestic community and outside, e.g. people, including businesses, can trade in goods and services with other people and businesses in the international community, and flow of funds as investment across the border...
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 is 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 priceLaw of one price
The law of one price is an economic law stated as: "In an efficient market, all identical goods must have only one price."-Intuition:The intuition for this law is that all sellers will flock to the highest prevailing price, and all buyers to the lowest current market price. In an efficient market...
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
Efficiency (economics)
In economics, the term economic efficiency refers to the use of resources so as to maximize the production of goods and services. An economic system is said to be more efficient than another if it can provide more goods and services for society without using more resources...
common market from the fact that prices for the same good are different.
If a McDonalds patron in Zurich
Zürich
Zurich is the largest city in Switzerland and the capital of the canton of Zurich. It is located in central Switzerland at the northwestern tip of Lake Zurich...
were able to eat in an identical Moscow
Moscow
Moscow is the capital, the most populous city, and the most populous federal subject of Russia. The city is a major political, economic, cultural, scientific, religious, financial, educational, and transportation centre of Russia and the continent...
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 Moscow
Moscow
Moscow is the capital, the most populous city, and the most populous federal subject of Russia. The city is a major political, economic, cultural, scientific, religious, financial, educational, and transportation centre of Russia and the continent...
and Zurich
Zürich
Zurich is the largest city in Switzerland and the capital of the canton of Zurich. It is located in central Switzerland at the northwestern tip of Lake 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.
The price level
Measuring 'the' price level involves looking at goods other than burgers, but most goods in a consumer price indexConsumer price index
A consumer price index measures changes in the price level of consumer goods and services purchased by households. The CPI, in the United States is defined by the Bureau of Labor Statistics as "a measure of the average change over time in the prices paid by urban consumers for a market basket of...
(CPI) show the same pattern; equivalent things tend to cost more in high income countries. Most services, perishable goods like the Big Mac
Big Mac
The Big Mac is a hamburger sold by McDonald's, an international fast food restaurant chain. It is one of the company's signature products...
, 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 CPI level can vary from country to country, just like the burger price.
The international development implications
The PPP-deviation allows rural IndiaIndia
India , officially the Republic of India , is a country in South Asia. It is the seventh-largest country by geographical area, the second-most populous country with over 1.2 billion people, and the most populous democracy in the world...
ns 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
Ceteris paribus
or is a Latin phrase, literally translated as "with other things the same," or "all other things being equal or held constant." It is an example of an ablative absolute and is commonly rendered in English as "all other things being equal." A prediction, or a statement about causal or logical...
, 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
Tradable
Tradability is the property of a good or service that can be sold in another location distant from where it was produced. A good that is not tradable is called non-tradable. Different goods have differing levels of tradability: the higher the cost of transportation and the shorter the shelf life,...
, 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
Standard of living
Standard of living is generally measured by standards such as real income per person and poverty rate. Other measures such as access and quality of health care, income growth inequality and educational standards are also used. Examples are access to certain goods , or measures of health such as...
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 consumer price index.
See also
- The EconomistThe EconomistThe Economist is an English-language weekly news and international affairs publication owned by The Economist Newspaper Ltd. and edited in offices in the City of Westminster, London, England. Continuous publication began under founder James Wilson in September 1843...
s Big Mac IndexBig Mac indexThe Big Mac Index is published by The Economist as an informal way of measuring the purchasing power parity between two currencies and provides a test of the extent to which market exchange rates result in goods costing the same in different countries...
consistently shows fourfold differentials in the burger's pricePrice-Definition:In ordinary usage, price is the quantity of payment or compensation given by one party to another in return for goods or services.In modern economies, prices are generally expressed in units of some form of currency...
. - Purchasing Power ParityPurchasing power parityIn economics, purchasing power parity is a condition between countries where an amount of money has the same purchasing power in different countries. The prices of the goods between the countries would only reflect the exchange rates...
is the situation in which RERs are 1, a nil Penn effect.
Footnotes
1 For instance, economists in 1949 expected that one could buy similar quantities of meat in New YorkNew York
New York is a state in the Northeastern region of the United States. It is the nation's third most populous state. New York is bordered by New Jersey and Pennsylvania to the south, and by Connecticut, Massachusetts and Vermont to the east...
for one dollar as in Tokyo
Tokyo
, ; officially , is one of the 47 prefectures of Japan. Tokyo is the capital of Japan, the center of the Greater Tokyo Area, and the largest metropolitan area of Japan. It is the seat of the Japanese government and the Imperial Palace, and the home of the Japanese Imperial Family...
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 rate
Exchange rate
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...
s were not allowed to float
Floating exchange rate
A floating exchange rate or fluctuating exchange rate is a type of exchange rate regime wherein a currency's value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency....
to market levels by most of the world's central banks (before the 1970s and the end of the Bretton Woods
Bretton Woods system
The Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states in the mid 20th century...
era of gold convertibility).
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 equilibriumGeneral equilibriumGeneral equilibrium theory is a branch of theoretical economics. It seeks to explain the behavior of supply, demand and prices in a whole economy with several or many interacting markets, by seeking to prove that a set of prices exists that will result in an overall equilibrium, hence general...
derivation of the effect's size based on the BS-hypothesisBalassa-Samuelson effectThe Balassa–Samuelson effect, also known as Harrod–Balassa–Samuelson effect , the Ricardo–Viner–Harrod–Balassa–Samuelson–Penn–Bhagwati effect , productivity biased purchasing power parity and the rule of five eights is either of two related things:#The observation that consumer price levels...
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 dataCliometricsCliometrics, sometimes called new economic history, or econometric history, is the systematic application of economic theory, econometric techniques, and other formal or mathematical methods to the study of history . It is a quantitative approach to economic history...
. - 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 HoustonUniversity of HoustonThe University of Houston is a state research university, and is the flagship institution of the University of Houston System. Founded in 1927, it is Texas's third-largest university with nearly 40,000 students. Its campus spans 667 acres in southeast Houston, and was known as University of...
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.