A Spatial Explanation for the Balassa-Samuelson Effect

Peter Karadi and Miklós Koren

No 4, CeFiG Working Papers from Center for Firms in the Global Economy

Abstract: We propose a simple spatial model to explain why the price level is higher in rich countries. There are two sectors: manufacturing, which is freely tradable, and non-tradable services, which have to locate near customers in big cities. As countries develop, total factor productivity increases simultaneously in both sectors. However, because services compete with the population for scarce land, labor productivity will grow slower in services than in manufacturing. Services become more expensive, and the aggregate price level becomes higher. The model hence provides a theoretical foundation for the Balassa--Samuelson assumption that productivity growth is slower in the non-tradable sector than in the tradable sector. Empirical results confirm two key implications of the theory. First, we compare countries where land is scarce (densely populated, highly urban countries) to rural countries. The Balassa--Samuelson effect is stronger among urban countries. Second, we compare sectors that locate at different distance to consumers. The Balassa--Samuelson effect is stronger within sectors that locate closer to consumers.

Date: 2008-10-01, Revised 2008-10-01
New Economics Papers: this item is included in nep-geo and nep-int
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Working Paper: A Spatial Explanation for the Balassa-Samuelson Effect (2009)
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