The Balassa-Samuelson effect is one of the main explanations for why developing countries tend to have much lower overall price levels than rich countries, even when you convert currencies at market exchange rates.
The key idea is that workers' wages are tied together across different sectors of the economy, but productivity isn't.
Here's how it works.
Step 1: Divide the economy into two types of goods
Economists distinguish between:
- Tradable goods: products that can be sold internationally, like cars, electronics, steel, and wheat.
- Non-tradable goods: things that must be produced locally, like haircuts, restaurant meals, rent, medical services, and most local transportation.
Step 2: Rich countries are much more productive in tradable industries
Imagine two countries:
| Rich country | Developing country |
|---|
| Factory worker output | 100 units/day | 20 units/day |
Because factory workers in the rich country produce much more, firms can afford to pay much higher wages.
Suppose:
- Rich-country factory wage: $250/day
- Developing-country factory wage: $50/day
These differences largely reflect productivity.
Step 3: Wages spread across the whole economy
Workers can change jobs.
If factories pay $250/day, restaurants, hotels, and barbers also have to offer wages that are competitive enough to attract employees.
Even though a barber isn't exporting haircuts, the barber must compete for labor with factories.
So wages become high throughout the economy.
Step 4: Services become expensive
A haircut might require roughly the same amount of labor everywhere.
If:
- American barber earns $250/day
- Indian barber earns $50/day
then haircuts naturally cost much more in the United States.
The same applies to:
- restaurant meals
- cleaning services
- childcare
- plumbers
- dentists
- taxis
These services make up a large share of consumer spending, so the overall price level becomes much higher in richer countries.
Why aren't tradable goods much cheaper in poor countries?
Competition and international trade keep prices of tradable goods relatively similar.
For example:
- an iPhone
- a television
- copper
- soybeans
cannot have wildly different prices across countries because firms can import and export them.
Exchange rates and taxes matter, but globalization limits price differences.
The big differences appear in services and other non-tradable goods.
A simple example
Suppose making a haircut always takes one hour.
Rich country
Barber wage = $40/hour
Haircut price ≈ $50
Poor country
Barber wage = $5/hour
Haircut price ≈ $7
The haircut isn't lower quality because the barber is less productive.
It's cheaper because wages throughout the economy are lower.
Why are wages lower?
This is the heart of the Balassa-Samuelson effect.
Workers' wages are determined largely by their marginal productivity, especially in industries exposed to international competition.
If manufacturing productivity is:
- 5× higher in rich countries,
- then manufacturing wages become roughly 5× higher.
Those higher wages spill over into restaurants, construction, retail, education, healthcare, and many other local services.
What does this imply for exchange rates?
It helps explain why market exchange rates don't fully reflect differences in purchasing power.
Suppose:
- $1 buys one fast-food meal in the U.S.
- The equivalent local currency buys three similar meals in a developing country.
The developing country's currency appears "undervalued" if you only compare domestic purchasing power. This is why economists also use purchasing power parity (PPP) measures, which account for lower local prices. Developing countries typically have much higher GDP when measured at PPP than at market exchange rates.
Why the effect weakens as countries get richer
As a country industrializes:
- manufacturing productivity rises,
- wages rise,
- service prices rise,
- the overall price level converges toward that of richer countries.
This is exactly what has happened over recent decades in countries such as South Korea, Taiwan, and increasingly China. As incomes have increased, everyday services that were once extremely inexpensive have become much more expensive in international comparisons.
An important nuance
The Balassa-Samuelson effect is not the whole story. Other factors also contribute to lower price levels in developing countries, including:
- Lower land and property values in many areas.
- Lower productivity in non-tradable sectors themselves.
- Less stringent regulation or lower taxes in some markets.
- Differences in competition, infrastructure, and market efficiency.
Even so, economists generally view the Balassa-Samuelson effect as the primary structural reason why richer countries systematically have higher overall price levels. It links a country's productivity in internationally traded industries to economy-wide wages, which in turn determine the prices of locally produced goods and services.
