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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. more...

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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 the pattern changed, and the Penn study was the first to identify a modern trend; countries with higher incomes consistently had higher prices (as measured by comparable price indices).

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 ICP/PWT 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, 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 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.

Read more at Wikipedia.org