Why poor countries are cheap, and why it is not what you think

Ask most people why things are cheaper in a poorer country and you will get one of two answers. Either businesses there accept smaller profits, or the standards are lower and you are buying a worse thing.

Both are wrong, and you can prove it without leaving the shop. The can of Coke is the same can. The Big Mac is made to the same specification. The margins on a McDonald's franchise are not charity anywhere.

The real answer was worked out independently by two economists in 1964, and is named after both of them. It turns on a single fact: some jobs get more productive over time, and others cannot.

The haircut problem

Start with a question that sounds trivial. How many haircuts an hour could a barber do in 1900? Call it two or three.

How many can a barber do today? Two or three.

Now ask the same question about a car worker, or a farmer, or a person assembling electronics. The answers have moved by factors of ten, a hundred, sometimes more. A modern factory worker produces an amount of output per hour that would have looked like witchcraft to their great-grandparent doing the same nominal job.

So here is the puzzle. If a barber is no more productive than a barber a century ago, why does a haircut in a rich country cost the equivalent of a substantial chunk of a day's minimum wage, rather than what it cost in 1900?

Running it forwards

Follow the chain through and the price map falls out of it.

A country gets richer because its tradable sector, the part that makes things you can ship, becomes more productive. Higher productivity means those firms can pay more. To hire anyone at all, everyone else must pay more too, including the sectors that never got more productive: restaurants, haircuts, cleaning, childcare, hotels, the person behind the counter.

But those sectors did not get more efficient. They are paying more for the same amount of work. So their prices rise, and they rise permanently, relative to the price of the tradable goods that did get cheaper to make.

The end state is a country where a laptop costs about what it costs anywhere and a sandwich costs three times what it costs elsewhere. Which, if you have ever travelled from a middle-income country to a high-income one, is precisely the experience: the electronics feel normal and the lunch feels insane.

What gets expensive as a country gets rich

The Penn effect, which is the same fact from the outside

Economists have a second name for what this looks like in the aggregate. Convert every country's price level into a common currency at market exchange rates, plot it against income per head, and you get a clean upward slope: richer countries have higher price levels. It is called the Penn effect, after the dataset that first made it obvious.

The slope is the reason exchange rates mislead so badly. If you convert a Vietnamese salary into dollars at the market rate and compare it with an American one, you are implicitly pricing that salary as though it were being spent on tradable goods in the United States. Very little of a salary goes on tradables. It goes on rent, food prepared by someone, transport and services, all of which cost what they cost locally.

This is why the World Bank and the OECD publish purchasing-power-parity conversions at all, and why every serious cross-country income comparison uses them. The market exchange rate answers a question about capital flows. It was never designed to answer a question about living standards.

What this predicts, and where it fails

The theory earns its keep by being falsifiable, and the places it fails are informative.

It predicts that a country which gets rich quickly should see its non-tradable prices rise quickly. Broadly, this happens; the rising cost of services in fast-growing economies is one of the most reliable patterns in development.

It predicts that a country's price level should track its income. Mostly it does, but resource exporters break the pattern in both directions. A state that earns a great deal from oil without a large productive tradable sector can end up with high incomes and a distorted price structure, which is the phenomenon usually filed under Dutch disease.

And it predicts nothing at all about goods whose price is set by policy rather than cost, so fuel sits outside this entire framework and needs its own explanation.

The uncomfortable half

There is a version of this that gets said cheerfully, as though it were purely good news: things are cheap there, wages are high here, everyone is fine.

The arithmetic does not cooperate. If prices rise with income, then a poor country's cheapness describes its wages rather than offering its residents a discount. The bus fare is low because the driver's hour is worth little, and the driver is buying the same bus fare.

What a low price level genuinely does provide is a large advantage to anyone earning in a foreign currency and spending locally. It is why remittances go so far, why foreign pensions stretch, and why the arrival of enough remote workers earning rich-country salaries can push local prices up faster than local wages follow. That last effect is the least discussed and the most keenly felt.

The reason this site shows work-time alongside dollar prices is that the dollar column and the hours column tell opposite stories, and only one of them is about the person actually standing at the till.