Ever wondered why a simple haircut in India costs much less as compared to the US? Or why nannies can be really expensive in US as compared to India?But a laptop costs almost the same in India and the US. Why this difference exists? Why are prices of some goods and services the same whereas they vary widely in case of others?
The reason for this can be explained by what economists term as the “Balassa Samuelson effect”. The Balassa Samuelson effect captures the relationship between real exchange rate and productivity.It states:
- The traded good has the same price in both countries
- Productivity in traded goods determines wages
- Wages determine the prices of nontraded goods
Lets understand it in simple words:
The reason why the prices of some goods like laptop don’t vary is because if they vary, it would create opportunities for arbitrage. If you bought a laptop in India for $1,000 and sold it in US for $1,500; then eventually price in India will be raised to $1,500.Laptop is a traded good and hence its price does not vary much across countries.
But services like haircuts are not tradable. You won’t fly from US to India just because a haircut is cheap. Similar you cannot hire an India nanny to look after US kids. So for non –tradable services like salons, restaurants , baby sitting there is a local market. In case of US, the incomes are high and people can afford to pay more. So the price levels for these services are high in US. But how are incomes determined? Balassa-Samuelson effect states that productivity in traded goods determines wages. For countries with higher worker productivity, they can trade their goods abroad and hence get richer. Prices can also vary within a country. A haircut may cost more in places where rentals are high versus the place where rentals are low. This is because land is a key non tradeable good and prices of land vary widely across the country based on supply and demand.
Apart from Balassa Samuelson effect , price levels are also determined by exchange rate. For countries who try to depreciate their currencies to make exports attractive, the services are cheaper than they would be without the depreciation. A classic example of this case is China.
If we had to boil all this — Balassa-Samuelson effect, exchange rate down to a simple statement: it might be this: All things equal, prices rise fastest in the places where rich, talented people want to be.