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

We develop a general theory of regional (inter-city) price dispersion which also explains the ldquo;subnational Penn effectrdquo;, 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 ldquo;subnational Penn effectrdquo;. Furthermore, it shows that, contrary to the popular view, economic integration can increase as well as decrease spatial price variation