Balassa-Samuelson Hypothesis

The Balassa-Samuelson Hypothesis provides an explanation for the following feature of

the data: price of a comparable basket of goods and services is typically higher in developed
countries compared to developing countries.
To prove the hypothesis, we use a simple model consisting of two countries: Developed
(D) and Developing (G), and two goods: Traded (T) and Non-traded (NT). We proceed in four
steps.

Step 1: Observe that in equilibrium in a competitive market, the following relation must hold:

w = P × M P L,

where w, P and M P L denote the wage, price of the good and marginal product of labour
respectively. The latter measures the amount of output that an additional worker produces.
The left-hand side of the above equation is the cost of hiring an additional worker, while the
right-hand side is the additional revenue that this worker generates for the firm. Under perfect
competition, these two must be equal because there are zero profits. Using this relation, we get
the following expression for price:
w
P = . (1)
MP L

Step 2: The traded good, by definition, is available in both countries. Assuming that the cost
of trading is negligible, we must have

PDT = PGT .

Using (1),
wD wG
T
= .
M P LD M P LTG
In the above equation, we have used the result that there must be just one wage within a country
– one cannot have two distinct wages for the traded and non-traded goods because then workers
will produce only one good. Now, one of the most robust features of the data is that workers
in developed countries are significantly more productive than their counterparts in developing
countries in the manufacturing sector. Because traded goods are mostly manufactured goods,
we have the following:
M P LTD > M P LTG .

1
It then follows
wD > wG . (2)

Developed country workers earn a higher wage.

Step 3: The non-traded good consists mostly of services. For services, there is no clear ev-
idence that as a whole, developed countries have a productivity advantage (or disadvantage)
over developing countries. Hence, we have

M P LN T NT
D = M P LG .

Combining the above equation with (2), we can write

wD wG
NT
> .
M P LD M P LN
G
T

This is equivalent to
PDN T > PGN T .

Non-traded goods are more expensive in developed countries.

Step 4: A typical basket of goods consists of some traded and some non-traded goods. Let the
weight attached to traded goods in the basket be denoted by α. We then have the following:
Cost of basket in developed country = αPDT + (1 − α)PDN T .
Cost of basket in developing country = αPGT + (1 − α)PGN T .
Comparing the two costs and using the above results, we conclude that the basket costs more in
the developed country.