Purchasing Power Parity (PPP) states that the price of a good in one country is equal to its price in another country, after adjusting for the exchange rate between the two countries.
As a lightweight PPP annual test, The Economist has tracked the price of the McDonald’s Big Mac burger in many countries since 1986. Let’s take a look at this unique metric, known as the Big Mac PPP, and find out what the price of the ubiquitous Big Mac is in a given country can tell us about his wealth.
Key points to remember
- The Big Mac Index is a survey conducted by The Economist which examines the relative over or under valuation of currencies based on the relative price of a Big Mac across the world.
- Purchasing Power Parity (PPP) is the theory that the value of currencies will rise or fall to keep their purchasing power constant from country to country.
- The premise of the Big Mac PPP survey is the idea that a Big Mac is the same across the world. It has the same inputs and the same distribution system, so it should have the same relative cost from country to country.
How Purchasing Power Parity (PPP) Works
To illustrate PPP, assume that the exchange rate between the US dollar and the Mexican peso is 1/15 pesos. If the price of a Big Mac in the United States is $ 3, the price of a Big Mac in Mexico would be around 55 pesos – assuming countries have purchasing power parity.
If, however, the price of a Big Mac in Mexico were closer to 75 pesos, Mexican fast food store owners could buy Big Macs in the United States for $ 3, priced at 55 pesos, and sell them. each in Mexico for 75 pesos, making a risk-free gain of 20 pesos. (While this is unlikely with burgers in particular, the concept applies to other products as well.)
To exploit this trade-off, the demand for American Big Macs would push the price of the American Big Mac to $ 4, at which point Mexican fast-food owners would have no risk-free gain. Indeed, it would cost them 75 pesos to buy American Big Macs, the same price as in Mexico – thus re-establishing the PPP.
PPP also means that there will be parity between the prices of the same good in all countries (law of the single price).
In the example above, where the Big Mac is priced at $ 3 and 60 pesos, a PPP exchange rate of US $ 1 to 20 pesos is implied. The peso is overvalued against the US dollar by 33% (according to the calculation: (20-15) 15), and the dollar is undervalued against the peso by 25% (according to the calculation: (0.05-0.067 ) 0.067.
In the above arbitrage opportunity, the actions of many Mexican fast food store owners selling pesos and buying dollars to exploit price arbitrage would cause the value of the peso to fall (depreciate) and the dollar to rise. (to appreciate). Of course, the actions of exploiting a Big Mac are not enough on their own to drive a country’s exchange rate up or down, but if they are applied to all goods – in theory – it may be enough to change a country’s exchange rate to restore price parity. .
For example, if the price of products in Mexico is high compared to the same products in the United States, American buyers would favor their domestic products and avoid Mexican products. This loss of interest would eventually force Mexican sellers to lower the price of their products until they were on par with American products.
Alternatively, the Mexican government could allow the peso to depreciate against the dollar, so that American buyers no longer pay to buy their goods in Mexico.
Short-term parity versus long-term parity
Empirical evidence has shown that for many goods and baskets of goods, ASF is not observed in the short term, and there is uncertainty about its long term application. Pakko and Pollard cite several confounding factors as to why the PPP theory does not correspond to reality in their article âBurgernomicsâ (2003). The reasons for this differentiation include:
- Transport costs. Goods that are not locally available will have to be imported, resulting in transport costs. Imported products will therefore sell for a relatively higher price than the same products available from local sources.
- Taxes. When government sales taxes, such as value added tax (VAT), are high in one country compared to another, it means that the goods will sell for a relatively higher price in the country where the taxes are. high.
- Government intervention. Import tariffs are added to the price of imported goods. When these are used to restrict supply, demand increases, which also leads to an increase in the price of goods. In countries where the same good is unlimited and abundant, its price will be lower.
Governments that restrict exports will see the price of a good rise in importing countries facing a shortage, and fall in exporting countries where its supply increases.
- Non-negotiated services. The price of the Big Mac is made up of the costs of inputs that are not traded. Therefore, these costs are unlikely to be on par at the international level. These costs can include the cost of premises, the cost of services such as insurance and utilities, and especially the cost of labor.
According to PPP, in countries where the costs of non-traded services are relatively high, the goods will be relatively expensive, resulting in an overvaluation of the currencies of these countries against the currencies of countries with low cost of non-traded services.
- Competition in the market: Products can be deliberately more expensive in a country because the company has a competitive advantage over other sellers, either because it has a monopoly or because it is part of a cartel of companies that manipulate the products. price.
The company’s sought-after brand could also allow it to sell at a higher price. Conversely, it can take years to come up with discounted products in order to establish a brand and add a premium, especially if there are cultural or political hurdles to overcome.
- Inflation: The rate at which the price of goods (or baskets of goods) changes across countries – the rate of inflation – can indicate the value of those countries’ currencies. Such a relative PPP overcomes the need for goods to be identical in the absolute PPP test discussed above.
The bottom line
PPP dictates that the price of an item in one currency should be the same in any other currency, based on the exchange rate of the currency pair at that time. This relationship often does not hold in reality due to several confounding factors. However, over a period of several years, when prices are adjusted for inflation, the relative PPP holds for some currencies.