The Penn Effect is that prices of goods and services in developed countries (DCs) are, after using market exchange rates, substantially higher than those in less-developed countries (LDCs). The World Bank in 2015 estimated that prices are more than three times higher in the US than in India. This price differential is huge. This raises some interesting questions.

Why aren’t very many tourists from the US attracted to India, if the prices are very low in India? Also, the price differential can be attractive to migrants who had initially shifted from India. In their retirement years, the migrants could return home but this hardly happens.

Prices in the US are, as mentioned earlier, more than three times the prices in India. Let us consider this number in perspective. Pension funds in the US are, as discussed by Richard A. Marin, still going through a near-crisis as they have large unfunded liabilities. The size is still debated. If the shortfall is a quarter of the liabilities, then on one hand, a shortfall of 25% is viewed as a near-crisis. On the other hand, there is an opportunity to get 200% more by shifting to India! But we do not see this behaviour.

There are other examples as well. Financially constrained students in the US hardly ever consider India for higher education even though the fees can be even less than one-third. The usual explanations lie in non-economic factors. There is indeed merit in such explanations. However, there can be, as new research by this author shows, a simple economic factor: while the observed prices are indeed low, the effective prices are not very low in India.

It is usual to view only the money paid for a good or service as the price, and rightly so—in the context of DCs. However, in LDCs, there can be an additional price. So, the effective prices in LDCs are not as low as the observed prices are. The basic reason is as follows. There are some well-known features of an LDC; these are usually viewed as part of the narrative that describes an LDC, and nothing more from the viewpoint of pricing in LDCs. However, pricing in LDCs can be different and more complex than in DCs; the money price is not the only price. There are other considerations which make the effective prices higher than the observed prices in LDCs.

There can be various adjustments to observed prices, which are required to arrive at effective prices in LDCs. A brief explanation is as follows. First, it takes more time and trouble to buy goods and services in India. For example, an Uber ride is much cheaper monetarily in India but it typically takes much longer to cover the same distance—thanks to the traffic and road conditions in India. So, the time-adjusted price in India is not as low as the observed price is.

Second, there is often a negative externality, which is not accounted for in the observed price. Hawkers operate on the roadside; their prices are low but their operations can slow down the traffic movements and cause difficulties to very many people every day. While goods can be cheap for a homemaker, the same feature can be troublesome for the spouse and other family members who use the road for commuting and making a living. So, the “externality"-adjusted price is not as low as the observed price is.

Third, there is often a risk in purchases. For example, medical charges can be relatively low in India but there is a question mark about the competence of a medical practitioner (and even about the arrangements in many hospitals). So, the risk-adjusted price can be higher than the observed price.

Fourth, quality is low in India. This is well known but not adequately appreciated. For example, while the cost of higher education in India is low, the quality too is typically quite low. So, the quality-adjusted price of education can be high in India.

In LDCs, the distinction between effective prices and observed prices is very important. In contrast, in DCs, there is hardly any need to make such a distinction, given the nature of those economies. So, the effective prices are much closer to the observed prices in DCs.

It is interesting that the Penn Effect is consistent with “catch-up inflation". The latter refers to the idea that as a country like India develops and shifts from being an LDC to becoming a DC in future, prices will rise (over and above what is implied by the more familiar inflation). A little reflection will show that there is a close similarity between the two ideas.

However, the idea of “catch-up inflation" has not been widely accepted in the economics literature. Given this somewhat widespread view, consistency demands that economists should question the Penn Effect as well. This is hardly observed in practice. This column differs with the usual view and it questions not only “catch-up inflation" but also the Penn Effect.

If prices are more than three times higher in the US than in India, the exchange rate based on purchasing power parity (PPP) is less than Rs21.38 per dollar (21.38=64.13/3, where 64.13 is the market price of dollar in terms of rupees on 23 August). Now the concept of PPP is basically sound. However, it uses observed prices. If observed prices are adjusted to arrive at effective prices, this leads to the new notion of adjusted-PPP.

It is true that the use of market exchange rates can underestimate the gross domestic product of a country like India relative to that of a DC. So many economists advocate the use of exchange rate based on PPP. However, this can overestimate the GDP in India. So, it may help to consider adjusted-PPP to get the correct picture.

Gurbachan Singh is an independent researcher and visiting faculty at the Indian Statistical Institute, Delhi centre.

Published with permission from Ideas For India (Ideasforindia.in), an economics and policy portal.

Comments are welcome at theirview@livemint.com

Subscribe to Mint Newsletters * Enter a valid email * Thank you for subscribing to our newsletter.

Share Via