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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.
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 the different currencies used in each country were converted into some common standard (like gold) at the floating nominal exchange rate. 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 sometime 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).
Understanding the Penn effect
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 (na´ve 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 and Russian burger prices to converge on the $3 US 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 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 McDonalds patron in Zurich was able to eat in an identical Moscow restaurant at quarter the price she 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 it isn't economical to dine in Moscow if you happen to start the evening in Zurich.
The price level
Measuring 'the' price level envolves looking at goods other than burgers, but must goods in a price index (CPI) show the same pattern; equivalent things tend to cost more in high income countries. Most services, perishable goods link 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.
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 did not apply, millions of the world's poorest people would find that their real 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 exagerated 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.
- The Economist's Big Mac Index consistently shows four-fold differentials in the burger's price.
- Purchasing Power Parity is the situation in which RERs are 1, a nill Penn effect.
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