Burgernomics and Purchasing Power Parity

Transcription

1 1 Burgernomics and Purchasing Power Parity (Submitted to Economics Review published by Peoples Bank of Sri Lanka January 2015) Ms. H.M.S. Amanda Herath Lecturer, Department of Business Economics, Faculty of Management & Finance, University of Colombo Abstract This article tries to explain the not so digestible concept of Purchasing Power Parity Theory using something digestible and tasty as a Big Mac burger. The article will explain in a step-by-step method the logic and the need of such a concept. Then it will explain the economic application of the concept while concluding with an analysis why the concept cannot be observed in the day to day world. Have you ever tried a Big Mac burger at a McDonald s restaurant? Do you know that apart from certain special instances this Big Mac burger contains similar ingredients in almost all the McDonald s restaurants around the globe? The Big Mac was created in 1967 by Jim Delligatti, a McDonald s franchise owner in Pennsylvania. In 1968 the Big Mac was launched in McDonald s restaurants throughout the United States, and it is now possible to purchase the sandwich in 120 countries around the globe. In each of these countries, the Big Mac is generally made according to the same recipe two all-beef patties, special sauce, lettuce, cheese, pickles, onions on a sesame seed bun (Pakko and Pollard, 2003). Apart from being a popular snack, since 1986 this Big Mac has entered into the economic textbooks with the introduction of the Big Mac Index by The Economist Magazine in The Economist magazine introduced the Big Mac Index as a light hearted guide to explain the concepts of Law of One Price and Purchasing Power Parity Exchange rates. Even though it does not satisfy the demanding tests of PPP requirements in a strict academic sense, the light-hearted method of using Big Mac as a starting point for understanding PPP theory has gained popular attention hence coined as Burgernomics. Getting Started with Burgernomics If this special burger contains same ingredients no matter where it is sold on the earth, then shouldn t it carry the same price tag? In other words, one can logically expect a Big Mac to

2 2 have the same price both in U.S, China and Sri Lanka. This logical expectation has a technical jargon in economics. That is The Law of One Price (LoOP). The Law of One Price states that identical goods sell for the same price in two separate markets when there are no transportation costs and no differential taxes applied in the two markets. Consider the following example; Price of a Saree in Sri Lanka - Sri Lankan Rupees 1500/- Price of a Saree in India - Indian Rupees 600/- Exchange rate published by the Central Bank - 2/- Sri Lanka rupees per 1/- Indian Rupee Price of an Indian Saree in Sri Lanka Rupees = 600* 2 = 1200/- Sri Lankan Rupees Price of a Sri Lankan Saree in Indian Rupees= 1500/2= 750/- Indian Rupees If both Sarees are identical, then according to the Law of One Price the sarees should have the same price when both prices are converted into either Sri Lankan rupees or Indian rupees. But according to the above example this seems not be the case. It is cheaper to buy a saree from India and sell it in Sri Lanka and the seller can make a profit if he can avoid the transportation cost of bringing the saree from India to Sri Lanka and any applicable tariffs and taxes charged at the Sri Lankan customs. If both sarees are identical then why they have different prices in Sri Lanka and India? The same question can be raised about the Big Mac burger. As you can observe in the fourth column of the following table, the dollar price of a Big Mac burger is different from country to country.

3 3 Table 1 Big Mac Prices around the World Country Local Nominal Dollar Price PPP Undervaluation/ Currency Exchange (Local dollar Overvaluation Price in Rate Currency Jan 2015 (Local Currency Units per US Dollar) Price/Nominal Exchange Rate) Argentina Australia Brazil Britain Canada Chile China Colombia Costa Rica Czech Republic Denmark Egypt Euro area Hong Kong Hungary India Indonesia Israel Japan Malaysia Mexico New

4 4 Zealand Norway Pakistan Peru Philippines Poland Russia Saudi Arabia Singapore South Africa South Korea Sri Lanka Sweden Switzerland Taiwan Thailand Turkey UAE Ukraine United States Uruguay Venezuela Vietnam Austria Belgium Estonia Finland France Germany

5 5 Greece Ireland Italy Netherlands Portugal Spain Source-The Economist Big Mac Index Data - Table 1 summarizes the Big Mac prices for 2015 January of 57 countries, converted into US dollar value. If we assume that the the law of one price holds true then this identical Big Mac should have the same dollar price all over the world. But due to the differences in the nominal exchange rates used for converting the local prices into dollar prices, the law of one price does not hold true in the above scenario. How can we adjust the nominal exchange rate to depict equal prices for the same good sold in different places? If we presume that the item sold should have equal prices everywhere around the world then the problem lies with the nominal exchange rate, which fails to capture the actual purchasing power of different currency units used in different countries. Consider the following; In Argentina A Big Mac costs - 28 Argentine pesos. In US A Big Mac costs US dollars The Nominal Exchange rate is 8.61 pesos for a US dollar If we use the nominal exchange rate to convert the Argentine Big Mac price then a Big Mac would cost= 28/8.61 = 3.25 US dollars In that sense 1 Argentine Peso= 1$/8.61 pesos = US dollars If the law of one price holds true then the PPP exchange rate should be = 28/4.79= 5.85 pesos for a US dollar In that sense 1 Argentine Peso= 1$/5.85 pesos= US dollars In fact the prevailing nominal exchange rate underestimates the purchasing power of the Argentine peso with respect to US dollar. According to the prevailing exchange rate one

6 6 should spend 8.61 pesos to buy a dollar, but if the law of one price holds true then it would cost only 5.85 pesos to buy a dollar. This adjusted exchange rate which captures the purchasing power of a currency unit is called the Purchasing Power Parity Exchange Rate. Purchasing Power Parity Exchange Rate (PPP) is defined as that rate which equalizes the cost of a market basket of identical goods between two countries. Burgernomics simply substitutes the price of a Big Mac to represent the cost of a market basket of identical goods, since it carries the same ingredients everywhere. In the above table column 5 indicates the PPP exchange rate calculated using the Big Mac prices. The calculated PPP exchange rate equalizes the purchasing powers between the Argentine pesos and US dollars. In the above example since the nominal exchange rate underestimates the purchasing power of pesos with respect to dollars we say that the peso is undervalued with respect to dollars in PPP terms. We can calculate the amount of undervaluation as follows; [(PPP dollar exchange rate- Nominal Exchange Rate)/Nominal Exchange Rate]*100 If this value yields a negative value it indicates that the local currency (peso) is undervalued with respect to the PPP exchange rate. On the other hand this also implies that the US dollar is overvalued with respect to PPP exchange rate of peso. In such a situation a US tourist who converts his dollars at the nominal exchange rate into Argentine pesos when touring Argentina will find that Argentine goods are cheaper than US goods. Because the nominal exchange rate tends to overestimates the purchasing power of dollars. Therefore the US traveller can buy more goods and services with a dollar in Argentina than he can buy in his own country. Meanwhile an Argentine tourist who does the opposite will find that US goods are more expensive than Argentine goods. Again this is because the nominal exchange rate underestimates the purchasing power of pesos. The Argentine tourist will find that he have to pay more pesos to the same amount of goods than he has to pay in his own country. If the result of the above formula carries a positive value then it indicates that the local currency is overvalued with respect to the PPP exchange rate. Consider the situation in Sweden. One has to pay less number of Swedish Krona for purchasing a dollar under nominal exchange rate than he has to pay under PPP exchange rate. In such a situation the Swedish Krona is said to be overvalued against US dollar with respect to the PPP exchange rate, while the US dollar is said to be undervalued against Swedish Krona with respect to the PPP

7 7 exchange rate. In another sense a US tourist who changed his US dollars in to Swedish Krona under the prevailing exchange rate will find that prices are high in Sweden than in US. The opposite will be true for a Swedish traveller. He will find that prices in US are relatively cheaper than in Sweden. Figure 1 Source- The Economist Big Mac Index Column 6 of Table 1 indicates the overvaluation or undervaluation of various currencies with respect to PPP US dollars exchange rate calculated using the Big Mac prices for January The Economist Magazine offers a graphical representation as well (Figure 1). As per those calculations you can see that even the Sri Lankan rupee is undervalued with respect to US dollar. The purchasing power of the Sri Lankan rupee is not correctly reflected in the nominal exchange rate. As you are well aware in the real world we never use the PPP exchange rate to change the international currencies. We only use the prevailing nominal exchange rates when we are dealing with the foreign currencies, even though that rate may overvalue or undervalue the purchasing power of the currencies. Then why do we spend so much time to conceptualize and understand the concept of PPP exchange rate?

8 8 Application of PPP theory The most important application of PPP exchange rates is in making cross country comparisons in income, wage rates or GDP. When we compare the well-being of the countries we usually compare the GDP per capita of countries. In order to do this comparison we usually convert the GDP values calculated in respective local currencies into US dollars. When nominal exchange rates are used for this conversion the well-being status of some countries are grossly underestimated or grossly overestimated when compared to other countries. If we take such values we cannot ascertain the real state of well-being of countries. When we use the PPP exchange rate for this conversion we can harness the actual purchasing power of the per capita income hence the real state of well-being of countries. Table 2- Per Capita GDP for some selected countries Country Per capita GDP at Per capita GDP Current US $ for 2012 at Current PPP $ for 2012 Armenia Australia Bangladesh Belgium Brazil China Congo, Dem. Rep Denmark India Sri Lanka Sweden

9 9 Sweden Sri Lanka India Denmark Congo, Dem. Rep. China Brazil Belgium Bangladesh Australia Armenia GDP at Current PPP $ GDP at Current US $ Figure 2 Source- World Bank Data Consider the case with regard to Armenia and Australia (Table 2 and Figure 2). When we use the nominal exchange rate for converting GDP per capita into a common dollar value we can see that Australia s per capita GDP is 20 times higher than Armenia s per capita GDP. Is it the true story? Are Armenians 20 times poorer than Australians? As we have already discussed the price levels of the two countries can be considerably different. Even though Australians seem to have 20 times higher income than Armenians that does not necessarily mean they can purchase 20 times more than Armenians. In Australia the same good can be more expensive than in Armenia. Therefore we need to eliminate this price level difference before comparing the GDP per capita across countries. Recall that PPP exchange rate equalizes the prices of an identical basket of goods. Therefore we can use the PPP exchange rate to convert the GDP per capita data into a common currency. That common currency would be the PPP dollar. In a sense this PPP dollar will buy the same amount of goods and services anywhere on earth. When we use the PPP dollar exchange rate to calculate the GDP per capita, we can see that Australian per capita GDP is only 5 times higher than Armenian per capita GDP. Even though Australians still have a better per capita than Armenians, it is not grossly overestimated as before. The PPP conversion method has become the standard method used by the World Bank and other researchers in making cross country comparisons of GDP, GDP per capita etc. Even though the Big Mac Index served as a good starting point to understand the PPP exchange

10 10 rate concept it does not meet the rigorous standards of scientific valuations. For serious research purposes World Bank calculates PPP dollar exchange rates using the price levels of a carefully selected basket of goods and services. For most comparisons concerning the size of economies or standard of living, using PPP is a more accurate method and can fundamentally change our perception of how countries compare. Suppose we want to know the countries which have the highest GDP per capita in The following table (Table 3) presents the top 8 countries with the highest GDP per capita according to the current US dollars and PPP US dollars. The rankings of the countries as well as the countries which make into the top 8 positions are very much different when we use PPP dollar exchange rate. Table 3 Countries with Top 08 GDP per capita Country Per Capita GDP at Current US $ for Country Per Capita GDP at Current PPP 2012 $ for 2012 Luxembourg Luxembourg Norway Macao SAR, China Bermuda Qatar Switzerland Norway Macao SAR, China Singapore Australia Switzerland Denmark Brunei Darussalam Sweden Hong Kong SAR, China Source- World Bank Data

11 11 After this lengthy discussion of PPP exchange rates it is natural to come up with the obvious question. If PPP exchange rates give a correct picture of the purchasing power of the currencies, why we cannot observe it in the real world? Another way to put this question is Why we cannot observe the Law of One price in the real world? Understanding the Reality Transportation Cost- Prices of identical goods can differ from place to place due to the transportation costs. Depending on the distance from the source and convenience of transportation the prices of the same good sold in two different countries will be different. Trade Restrictions & Sales Taxes- National governments impose various taxes, tariffs and quotas against the goods imported and exported. Due to these added taxes the price levels will differ from country to country. According to Gustav Cassel (1921) the countries with high trade barriers will have overvalued currencies in comparison to other countries and the countries with low trade barriers will have undervalued currencies. In other words the price level of a country with high trade barriers tend to be high and the price level of a country with low trade barriers tend to be low. Non-traded goods- There are certain goods and services in an economy that cannot be sold across borders. For an example consider the rented business space. In order to operate a McDonald s restaurant the owners have to rent a business premises in that particular country. If that area is highly populated then ground rent can be considerably high. Expensive ground rents will be passed onto the Big Mac prices sold in that particular outlet. These non-traded goods which are not traded across the borders, such as water, electricity, ground-rent etc., can have a great impact on the relative price levels of countries. Productivity of labor and Wage differentials- A careful observation will reveal that Big Mac prices tend to be high in high income countries while the prices will be low in low income countries (Figure 3). This fact is true not just for Big Mac prices but for other goods as well. According to Balassa and Samuelson (1964) the reason for this observation is the productivity differences and the resulting wage differentials. According to them, these high income countries tend to have a high income because of their historically high levels of productivity. Since their labor force is comparatively more productive than their counterparts in low income countries the

12 Per Capita GDP in $ for wage rates paid to them are higher than the wage rates paid in low income countries. High wage rates mean high labor cost in production. This high labor cost will then be passed onto the product prices. Therefore high income countries tend to have high price levels compared to low income countries Big Mac Prices for 2012 January Figure 3 Source- World Bank Data and The Economist Big Mac Index Data Pricing Strategies (Pricing to Market) - The pricing strategy can have an impact on the differences of prices across the countries. According to a recent Forbes magazine article Mac Donald s pricing depends more on competition rather than on pure cost basis. According to Alessandria & Kaboski (2008) exporters tend to sell the identical goods at higher prices in high income countries than in low income countries. This price discrimination strategy also affects the relative price levels among countries. Demand Conditions - The prices vary depending on the demand conditions. In some countries Big Mac is a fast food item with high level of daily demand. Due to this high demand prices may rise. But in some countries it is a high-class food item with low levels of daily demand. In such countries cheap substitutes may be available as well. This low demand levels can drive down the Big-Mac prices in such countries. Customer Perceptions- People chooses to frequent McDonald s for more than the burgers, and these factors may be reflected in price differences across borders. The typical American view of McDonald s as a place to get a fast, cheap meal does not hold throughout the world. In many developing countries the Big Mac is not an inexpensive meal option. McDonald s in China attracts young urban professionals who see eating there as a way to connect with the outside world. For those who visit

13 13 Beijing from the Chinese countryside, McDonald s is viewed as a tourist stop. These rural visitors bring their Big Mac boxes home as souvenirs. These factors may be reflected in the price differences of a Big Mac around the world (Pakko and Pollard, 2003). PPP theory is one of the most important theories in International Economics and Finance. A Number of research efforts have focused on this topic. Big Mac Index serves as a simple, digestible starting point for this highly complex subject matter. Since its appearance in 1986, this light-hearted study of Big Mac international hamburger prices has been a popular example of the principles of PPP and has even given serious scholars food for thought. References- Alessandria, G, and J Kaboski Why Are Goods so Cheap in Some Countries? Business Review, Pakko, MR, and PS Pollard Burgernomics: A Big Mac TM Guide to Purchasing Power Parity. Federal Reserve Bank of St. Louis,