The Balassa–Samuelson effect, also known as Harrod–Balassa–Samuelson effect (Kravis and Lipsey 1983), the Ricardo–Viner–Harrod–Balassa–Samuelson–Penn–Bhagwati effect (Samuelson 1994, p. 201), or productivity biased purchasing power parity (PPP) (Officer 1976) is the tendency for consumer prices to be systematically higher in more developed countries than in less developed countries. This observation about the systematic differences in consumer prices is called the "Penn effect". The Balassa–Samuelson hypothesis is the proposition that this can be explained by the greater variation in productivity between developed and less developed countries in the traded goods' sectors which in turn affects wages and prices in the non-tradable goods sectors. Béla Balassa and Paul Samuelson independently proposed the causal mechanism for the Penn effect in the early 1960s. The theory The Balassa–Samuelson effect depends on inter-country differences in the relative productivity of the tradable and non-tradable sectors. The empirical “Penn Effect” By the law of one price, entirely tradable goods cannot vary greatly in price by location (because buyers can source from the lowest cost location). However most services must be delivered locally (e.g. hairdressing), and many manufactured goods such as furniture have high transportation costs (or, conversely, low value-to-weight or low value-to-bulk ratios), which makes deviations from one price (known as purchasing power parity or PPP-deviations) persistent. The Penn effect is that PPP-deviations usually occur in the same direction: where incomes are high, average price levels are typically high. Basic form of the effect The simplest model which generates a Balassa–Samuelson effect has two countries, two goods (one tradable, and a country specific nontradable) and one factor of production, labor. For simplicity assume that productivity, as measured by marginal product (in terms of goods produced) of labor, in the nontradable sector is equal between countries and normalized to one. where "nt" denotes the nontradable sector and 1 and 2 indexes the two countries. In each country, under the assumption of competition in the labor market the wage ends up being equal to the value of the marginal product, or the sector's price times MPL. (Note that this is not necessary, just sufficient, to produce the Penn effect. What is needed is that wages are at least related to productivity.) Where the subscript "t" denotes the tradables sector. Note that the lack of a country specific subscript on the price of tradables means that tradable goods prices are equalized between the two countries. Suppose that country 2 is the