Purchasing power parity

Based on Wikipedia: Purchasing power parity

The $5 Burger That Reveals Economic Truth

Here's a thought experiment that economists actually take seriously: What if you could measure the true wealth of nations using nothing but McDonald's hamburgers?

It sounds absurd. But the Big Mac Index, published by The Economist magazine since 1986, does exactly this—and it's caught governments lying about their own economies. In 2011, Argentina was exposed for manipulating its official inflation statistics when the price of a Big Mac in Buenos Aires didn't match what the numbers claimed.

This hamburger diplomacy points to something deeper: the simple fact that a dollar in New York is not the same as a dollar in New Delhi. Or rather, what that dollar can actually buy varies wildly depending on where you're standing when you spend it.

Economists call this concept purchasing power parity, often shortened to PPP. It's one of those ideas that seems obvious once you grasp it, yet its implications ripple through everything from how we measure poverty to whether China has actually overtaken the United States as the world's largest economy.

The Law of One Price (And Why It Fails)

The theoretical foundation of purchasing power parity rests on something called the law of one price. The logic is elegant: if you can buy a computer in New York for 500 US dollars, and the same computer costs 2,000 Hong Kong dollars in Hong Kong, then the exchange rate should be four Hong Kong dollars to one US dollar.

In a perfectly efficient world with no shipping costs, no tariffs, and no barriers to trade, this would hold true for everything. Prices would equalize across borders as traders exploited any differences.

But we don't live in that world.

Consider gasoline. In 2005, a gallon cost 91 cents in Saudi Arabia but $6.27 in Norway. That's a sevenfold difference for the exact same product. The reasons are obvious once you think about them: Saudi Arabia subsidizes fuel for its citizens and sits atop vast oil reserves, while Norway taxes gasoline heavily as environmental policy. Neither price reflects some universal "true" value of gasoline—they reflect local conditions, politics, and priorities.

And that's just for a commodity that actually gets shipped around the world. What about a haircut? A taxi ride? A meal at a local restaurant?

These services can't be exported. A barber in Bangkok isn't competing with a barber in Boston. Their prices reflect local wages, local rents, and local cost of living—not global markets.

Baskets Full of Reality

To work around these complications, economists don't compare single products. Instead, they compare entire baskets of goods—thousands of items, weighted by how much people actually consume.

The Organisation for Economic Co-operation and Development, known as the OECD, constructs its purchasing power parity calculations using roughly 3,000 consumer goods and services, 30 different government occupations, 200 types of equipment, and about 15 construction projects. This isn't a quick back-of-the-envelope calculation. It's a massive statistical undertaking.

The idea is to capture something close to actual living standards. If you can buy more food, more housing, more transportation, and more entertainment with your income in one country than another, then your purchasing power is genuinely higher—regardless of what the official exchange rate says.

But here's where it gets philosophically tricky: people in different countries consume different things.

Americans eat more bread. Chinese eat more rice. Ethiopians depend on teff, a grain that's essentially unavailable in Thailand. Thai workers live on rice that's not commonly sold in Ethiopia. How do you compare the purchasing power of an Ethiopian farmer with a Thai factory worker when they're buying completely different products?

You can't, really. At least not perfectly. The more similar two countries' consumption patterns are, the more meaningful a purchasing power comparison becomes. Comparing the United States to Canada yields fairly robust results. Comparing Norway to Nigeria is more like educated guesswork.

When Official Numbers Lie

Here's where purchasing power parity becomes genuinely important, not just academically interesting.

Some governments manipulate their exchange rates. They might peg their currency artificially high to make imports cheaper for citizens, or artificially low to boost exports. In these cases, the market exchange rate tells you almost nothing about what money is actually worth inside the country.

China is the classic example. For decades, economists argued that China kept the yuan artificially weak against the dollar, making Chinese exports cheaper on world markets. If you converted China's gross domestic product (GDP) to dollars at the official exchange rate, you got one number. If you converted it using purchasing power parity, you got a dramatically larger one.

The World Bank illustrated this starkly with 2003 data: one international dollar (a theoretical currency used for PPP comparisons) was equivalent to about 1.8 Chinese yuan in purchasing power terms. But the market exchange rate was considerably different. This meant China's economy looked much smaller when measured at market rates than when measured by what Chinese money could actually buy inside China.

The same pattern appears in India. At market exchange rates, India's GDP per capita in recent years was around $1,965. Adjusted for purchasing power parity, it jumped to about $7,197—more than three and a half times higher. Indians aren't suddenly richer when you use PPP. The measurement simply reflects that a dollar goes much further in Mumbai than in Manhattan.

At the other end of the spectrum, Denmark's nominal GDP per capita of around $53,000 drops to about $46,600 in PPP terms. Things are expensive in Copenhagen. A Danish salary buys less locally than the same salary would buy in most of the world.

The Great GDP Debate

So which number is "right"? Is China's economy bigger or smaller than America's? The answer depends entirely on what question you're actually asking.

The International Monetary Fund (IMF) has taken a clear position: for comparing the relative size of economies in the global marketplace, market exchange rates are more appropriate. Purchasing power parity captures domestic living standards better, but it's skewed by non-traded services that don't matter in international commerce.

Think about it this way. If China wants to buy American fighter jets, those jets cost dollars. China can't pay with the low haircut prices enjoyed by citizens in Chengdu. The market exchange rate determines China's purchasing power on the world stage, not the PPP rate.

But if you're asking whether the average Chinese citizen is better off than the average Indian citizen, PPP gives you a more meaningful answer. It accounts for the reality that Chinese wages, though modest by American standards, stretch much further when buying Chinese goods and services.

The Mexican Peso Paradox

Consider what happens when a currency crashes.

Imagine the Mexican peso loses half its value against the dollar overnight. Mexico's GDP, measured in dollars, instantly drops by half. Headlines scream about economic collapse.

But did Mexican workers actually become poorer?

If their wages in pesos stayed the same, and the prices of locally-produced goods stayed the same, then their ability to buy food, pay rent, and live their daily lives didn't change at all. They can still afford the same tacos, the same bus rides, the same domestic beer.

What changed is their ability to buy imported goods and to travel abroad. iPhones got more expensive. Vacations to Miami became unaffordable. But the domestic economy, measured in purchasing power terms, remained stable.

This is why economists use PPP-adjusted figures for comparing living standards across countries and across time. Market exchange rates are too volatile, too driven by speculation, currency trading, and capital flows that have nothing to do with how ordinary people live.

The Balassa-Samuelson Theorem

There's a deeper reason why market exchange rates systematically diverge from purchasing power parity, and it has to do with productivity differences.

Two Hungarian-American economists, Béla Balassa and Paul Samuelson, independently discovered this pattern in the 1960s. Their insight, now called the Balassa-Samuelson theorem, explains why prices are systematically lower in poorer countries.

Here's the logic. Rich countries are more productive at making tradable goods—cars, computers, machinery. This high productivity pushes up wages in those sectors. But wages tend to equalize across an economy: if factory workers earn good money, restaurants and barbershops have to pay decent wages too, or they won't find workers.

So in rich countries, services that require local labor—haircuts, restaurant meals, taxi rides—become expensive. The barber's productivity hasn't increased (cutting hair takes the same time it always did), but the barber's wages have risen alongside the economy.

In poorer countries, lower overall productivity means lower wages across the board. Services are cheap. A haircut in Manila costs a fraction of what it costs in Munich, even though the haircut itself is essentially identical.

This creates a predictable pattern: market exchange rates undervalue the currencies of developing countries relative to their purchasing power. The gap between PPP and market rates is itself an indicator of where a country sits on the development ladder.

The Statistical Nightmare

Computing purchasing power parity is surprisingly difficult.

Start with the basket of goods. Different organizations use different baskets and get different results. The OECD basket differs from the World Bank's International Comparison Program basket. The Geary-Khamis method for calculating PPP differs from the EKS method, which differs from the IDB method. Each approach has mathematical advantages and disadvantages, and none is definitively correct.

Then there's the quality problem. A car sold in Germany isn't the same as a car sold in Ghana, even if they share a brand name. Safety features differ. Reliability differs. Warranty terms differ. Is a German car "worth more" than a Ghanaian car? How much more?

Linking different regions of the world creates another headache. In major comparison exercises, economists select a list of identical items—around 1,000 products—that can be priced in at least two countries from each region of the world. These bridge items allow comparisons across regions. But the selection of bridge items itself introduces biases. If the bridging goods are more commonly consumed in rich countries, the exercise may overstate the purchasing power of poor countries.

And all of this assumes countries accurately report their data. The International Comparison Program requires participating nations to disaggregate their national accounts into detailed production and expenditure categories. Not all countries do this routinely or accurately. Statistical capacity varies wildly.

Predicting the Future

Despite all these measurement problems, purchasing power parity does something useful that market exchange rates cannot: it hints at where currencies might be heading.

Over long time periods—years, sometimes decades—market exchange rates tend to drift toward their PPP values. A currency that's undervalued relative to purchasing power will tend to strengthen. An overvalued currency will tend to weaken.

This doesn't happen quickly or smoothly. Speculation, interest rate differentials, and capital flows push exchange rates around in ways that can persist for years. But the gravitational pull of purchasing power parity is real.

This makes PPP calculations valuable for long-term investors, for multinational corporations planning overseas expansions, and for governments thinking about currency policy. The PPP exchange rate is something like an anchor that market rates wobble around, sometimes drifting far away but eventually pulled back.

What Money Really Means

At its core, purchasing power parity forces us to ask what we actually mean when we talk about wealth.

Is a software engineer earning $200,000 in San Francisco richer than one earning $50,000 in Bangalore? In nominal terms, obviously yes. But after paying San Francisco rent, San Francisco taxes, and San Francisco prices for everything from coffee to childcare, how much is actually left? And does that remainder buy more life satisfaction than the Bangalore engineer's savings?

There's no objective answer. It depends on what you value, where you want to live, and what you consider a good life. But purchasing power parity at least tries to adjust for the reality that money is not an abstract universal unit. It's a claim on specific goods and services, available at specific prices, in specific places.

A dollar is not a dollar is not a dollar. What matters is what it can buy—and that varies more than most people realize.

The Limits of Comparison

Even the best purchasing power calculations cannot capture everything about living standards.

They can't measure safety. A city might have low prices but high crime rates, making the true "cost" of living there much higher than statistics suggest.

They can't measure environmental quality. Cheap goods produced in polluted factories impose health costs that never show up in price indices.

They can't measure political freedom, social trust, or the thousand intangible things that make life good or bad.

And they certainly can't capture the value of goods that don't exist in one of the countries being compared. How do you measure the purchasing power of access to a functioning democracy? Of clean drinking water? Of a hospital that actually has the medicine you need?

Purchasing power parity is a tool. Like all tools, it illuminates some things and obscures others. Used carefully, it reveals genuine truths about how economies differ. Used carelessly, it can mislead as easily as the nominal exchange rates it was designed to correct.

The Bottom Line

When someone tells you that China has or hasn't surpassed the United States as the world's largest economy, the answer depends entirely on how you measure.

At market exchange rates, the US economy remains larger. In raw dollar terms, American GDP exceeds Chinese GDP.

At purchasing power parity, China pulled ahead years ago. The Chinese economy produces more stuff, measured by what that stuff actually costs to produce and buy locally.

Neither number is the "true" size of these economies. They're measuring different things. Market rates capture international economic power—the ability to buy foreign goods, invest abroad, and project financial influence. Purchasing power captures domestic economic activity—what people are actually making and consuming in their daily lives.

The same principle applies all the way down to individual experience. Your salary number means less than what that salary can buy where you live. A smaller paycheck in a cheaper city might leave you richer than a bigger paycheck in an expensive one.

This is the insight at the heart of purchasing power parity: wealth is not abstract. It's concrete. It's the food on your table, the roof over your head, the goods and services you can actually obtain. Numbers on a page or digits in a bank account only matter insofar as they translate into real things in the real world.

The economists had it right all along. You really can learn something important about the global economy from the price of a hamburger.