Accounting for the 'Subnational Penn Effect' — A General Theory of Regional and National Price Levels

Abstract

We develop a general theory of regional (inter-city) price dispersion which also explains the “subnational Penn effect”, i.e. cross-city correlations among population size, prices, real income and human capital stock. As a version of the neoclassical urban systems theory (Henderson, 1974), our model features a trade-off between agglomeration economies in production and urban congestion costs associated with increased land and service prices that brings forth differentiated cities. We explain the circular mechanism that translates a high land price to high local service prices. The model is also a theory of international price dispersion that is observationally equivalent to and more appealing than the Balassa-Samuelson theory, with the implication that the (international) Penn effect may simply be an aggregate result of the “subnational Penn effect”. Furthermore, it shows that, contrary to the popular view, economic integration can increase as well as decrease spatial price variation.