Béla Balassa and Paul Samuelson independently proposed the causal mechanism for the Penn effect in the early 1960s.
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.
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.
This may be treated as anecdotal evidence in favour of the Balassa–Samuelson hypothesis, since supermarket beer is an easily transportable, traded good.
The BS-hypothesis explanation for the price differentials is that the 'productivity' of pub employees (in pints served per hour) is more uniform than the 'productivity' (in foreign currency earned per year) of people working in the dominant tradable sector in each region of the country (financial services in the south of England, manufacturing in the north).
Bahmani-Oskooee and Abm (2005) & Egert, Halpern and McDonald (2006) also provide quite interesting surveys of empirical evidence on BS effect.
Panel data and time series techniques have crowded out old cross-section tests, demand side and terms of trade variables have emerged as explanatory variables, new econometric methodologies have replaced old ones, and recent improvements with endogenous tradability have provided direction for future researchers.
A deeper analysis of the empirical evidence shows that the strength of the results is strongly influenced by the nature of the tests and set of countries analyzed.
Therefore, most of the contemporary authors (e.g.: Egert, Halpern and McDonald (2006); Drine & Rault (2002)) analyze main BS assumptions separately: Refinements to the econometric techniques and debate about alternative models are continuing in the International economics community.
For instance, other effects of exchange rate movements might mask the long-term BS-hypothesis mechanism (making it harder to detect if it exists).
In a 2001 International Monetary Fund working paper Macdonald & Ricci accept that relative productivity changes produce PPP-deviations, but argue that this is not confined to tradables versus non-tradable sectors.
Quoting the abstract:An increase in the productivity and competitiveness of the distribution sector with respect to foreign countries leads to an appreciation of the real exchange rate, similarly to what a relative increase in the domestic productivity of tradables does.Capital inflows (say to the Netherlands) may stimulate currency appreciation through demand for money.
As the RER appreciates, the competitiveness of the traded-goods sectors falls (in terms of the international price of traded goods).
Yves Bourdet and Hans Falck have studied the effect of Cape Verde remittances on the traded-goods sector.
[2] They find that, as local incomes have risen with a doubling of remittances from abroad, the Cape Verde RER has appreciated 14% (during the 1990s).
The export sector of the Cape Verde economy suffered a similar fall in productivity during the same period, which was caused entirely by capital flows and not by the BS-effect.
[note 2] Rudi Dornbusch (1998) and others say that income rises can change the ratio of demand for goods and services (tradable and non-tradable sectors).
A shift in preferences at the microeconomic level, caused by an income effect can change the make-up of the consumer price index to include proportionately more expenditure on services.
This alone may shift the consumer price index, and might make the non-traded sector look relatively less productive than it had been when demand was lower; if service quality (rather than quantity) follows diminishing returns to labour input, a general demand for a higher service quality automatically produces a reduction in per-capita productivity.
If the traded/non-traded consumption ratio is also correlated with the price level, the Penn effect would still be observed with labour productivity rising equally fast (in identical technologies) between countries.
Lipsey and Swedenborg (1996) show a strong correlation between the barriers to free trade and the domestic price level.
This explanation is similar to the BS-effect, since an industry needing protection must be measurably less productive in the world market of the commodity it produces.
However, this reasoning is slightly different from the pure BS-hypothesis, because the goods being produced are 'traded-goods', even though protectionist measures mean that they are more expensive on the domestic market than the international market, so they will not be "traded" internationally[note 3] The supply-side economists (and others) have argued that raising international competitiveness through policies that promote traded goods sectors' productivity (at the expense of other sectors) will increase a nation's GDP, and increase its standard of living, when compared with treating the sectors equally.