Why Some Countries and Cities Are So Much More Expensive Than Others

By Derek Thompson

Our special report on the world of prices wouldn't be complete without asking, and trying to answer, a big, and surprisingly complex, question: How do pricey countries get that way?

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Reuters

Zenaide Muneton is a nanny in New York City. Last year, she made more than $200,000, Planet Money reports. Yes, with five zeros.

How in the world can Manhattan nannies be worth $200,000 a year? One answer is that they're more talented than your typical babysitter. The highest-paid nannies can cook four-course macrobiotic meals and know their way around a Zamboni (those are actual examples of nanny skills). But the number-one reason why nannies in Manhattan can get paid $200,000 is very simple. Rich families can afford it. And in the market for locally-delivered services, like caring for a child, prices rise as high as the clientele can afford to pay.

What $200,000 nannies have to do with the price of tea in China

Six-figure nannies don't rule the world, but they help explain the world of prices. On a global scale, the price of locally-delivered services, such as nannies and barbers, fluctuate wildly from country to country. A simple haircut in Uzbekistan is much, much cheaper than a simple haircut in Beverly Hills. But lots of goods can be bought and enjoyed thousands of miles away from where they're made, like automobiles and paintings. If you're in the market for an original Picasso, it won't matter whether you buy the painting in China or in the United States. It will cost the same price anywhere, because the painting can be "consumed" anywhere.

So, some prices vary wildly from country to country, and some prices don't. What's the difference?

THE NANNY EFFECT

If the answer is obvious to you, then you just might be smarter than some of the 20th century's most brilliant economists, who spent decades building a framework for finding out why some prices between countries (and even between cities in the same country) differ so dramatically. The most elegant of these theories is known, less elegantly, as the Balassa-Samuelson Effect, after two economists Béla Balassa and Paul Samuelson. The Balassa-Samuelson Effect is a mouthful. Let's call it the "Nanny Effect."

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In a nutshell, the Nanny Effect says that the price of some goods -- e.g.: Picasso paintings, barrels of oil, bricks of gold, and company stock -- shouldn't vary much by location, because it would create opportunities for arbitrage. If you bought a gold brick for $10 in Peru and sold it for $100 in the United States, Lima sellers would raise their price toward $100.

But most services aren't like gold bars. They're delivered locally and consumed locally. You're not hiring a Bangalore nanny to look after your kids, and you're not flying to Shenzhen for a haircut. From the dry-cleaner, to the restaurant, to the hairdresser, most of the jobs in a service economy have a local clientele. In cities where incomes are high, average price levels for these services are typically high. Where incomes are low, average price levels are low.

But how do incomes go from low to high? Balassa and Samuelson said it must come down to workers' productivity, especially in the sectors that can "trade" their goods and services abroad. If a country gets better at making cars it can sell to foreigners for money, it gets richer. As income and investment flows into a country, incomes rise and prices rise across the board -- even for the haircuts and the nannies.

WHY IS INDIA SO CHEAP? ... AND WHY IS ZURICH SO EXPENSIVE?

On Tuesday, and my roommate Shyam emailed from Mumbai to brag about the cheap food. Ordering "a full lunch of a rice, naan and three curries for, oh, about $1 is pretty great." It sure is, Shyam. But if he had visited ten years ago, it might have been closer to 50 cents. As India has become more productive over the last few decades, wages in the tradable sector (IT) rose, pulling up wages in the nontradable sector (waiters), and the currency has appreciated. There is a still a major price difference D.C. and Delhi. One dollar will pay for much less stuff in America than its equivalent in rupees will buy in India. But as Indian exports continue to grow, one should expect Shyam's lunch to get more and more expensive.

There is much more to price levels than the Nanny Effect. Much, much, much more. Restrictive urban policy raises the price of rent in similarly productive cities. Energy policies and levies raise or lower the price of gas. Tariffs raise the price of imports. On a nation-by-nation basis, taxes restrain demand and subsidies increase supply on an idiosyncratic basis.

But perhaps the easiest way to mess with Balassa and Samuelson is for a government to manipulate foreign exchange rates. China, for example, is famous for pegging its currency to the U.S. dollar to make its exports more competitive. As a result, services in China are probably cheaper than they would be if the government weren't actively trying to depreciate the currency. If you're happily wondering "Why is China so cheap?" you should thank Beijing.

"The B-S Effect [er, Nanny Effect!] explains why on average, prices vary across countries, but in the short to medium run, the exchange rate will also determine how cheap or expensive different countries are," economist Arvind Subramanian told me.

Another way to see this in action is to read the Economist's latest cost-of-living index for cities, an sample of which are in the graph below. The top of the list was dominated by Switzerland (and, to a lesser extent, Japan and Australia). Why Switzerland?

Blame Greece and Germany. The debt crisis sweeping Europe has created a flight to safety to Swiss Francs, which are considered safer. As the Franc appreciated, prices have gone up compared to the euro and the dollar. Japan and Australia have also seen strong currency appreciation over the last few years, which made it relatively expensive for foreigners.

LAND AND RICHES

Even within a country, prices vary dramatically. The same beer might cost more downtown than in the suburbs. A barber might cost more in San Francisco than Detroit. Let's conclude with another fundamental ingredient in prices. Land.

"Land is the key non-tradable good" in cities, Subramanian told me. It's adheres to the Nanny Effect even more than nannies. If rents are going down in El Paso, you can't take advantage of that fact while you're living in Boston. That's why housing rentals vary by thousands of percent among cities in different parts of the world. Rents rise when demand to live in an area goes up, and they fall when the supply of rental units outpace that demand. The price of real estate has a way of showing up in price tags all over the city. Ice cream shops, massage parlors, and architects charge more in cities with higher rental prices.

The unique case of Zenaide Muneton, our superstar nanny, is a story about land, to a degree, but it's more a story about people. Manhattan has $200,000 nannies because that's the little island where some of the richest and most talented people work and can afford the richest and most talented caretakers for their kids. If we had to boil all this -- Balassa-Samuelson, Nanny Effect,exchange rates, urban policy -- down to a sentence, it might be this: All things equal, prices rise fastest in the places where rich, talented people want to be.

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This article available online at:

http://www.theatlantic.com/business/archive/2012/03/why-some-countries-and-cities-are-so-much-more-expensive-than-others/255238/