Friday, September 21, 2007

Why does a Big Mac cost less in China?

In July of this year, the Economist reported that a a Big Mac cost $7.61 in Iceland, $3.41 in the United States, and only $1.45 in China. The theory of Purchasing Power Parity says that arbitrage should push these prices together. The idea is that if goods are cheaper in China, exporters are more likely to ship them to the US, or tourists are more likely to travel to China to buy them. This will increase demand for Chinese yuan, drive up the exchange rate, and raise the price (in dollars) of the Chinese Big Mac. That this does not seem to happen is one of the biggest puzzles in economics.

Not so fast says colleague David Parsley and Shang-Jin Wei. In a new paper, find that price convergence is masked by the use of different price indexes in different countries (sushi in Japan, burgers in America). Once you look at individual goods, like the Big Mac, globalization really does push international prices closer together. These price diffrences will tend to disappear.

What this means is that the Economists "Big Mac Index" (explanation, video) can tell you which currencies are over-valued (Iceland), or undervalued (China) relative to the dollar. It seems as if economists are just finding out what currency traders knew all along.

3 comments:

  1. Because people are scared of lead-painted big mac imported from China?

    ReplyDelete
  2. Did you read the latest news?

    "Mattel declared that the majority of the more than 21 million toys it has recalled in recent months resulted from Mattel design problems, not Chinese manufacturing issues."

    ReplyDelete
  3. I enjoyed talking about PPP during my International Finance course. It was probably one of the most enlightening concepts discussed. My favorite, though, was discussing reasons WHY it didn't hold!

    First, it may be fruitful to note the gist of PPP: that prices across open borders will converge, adjusted for exchange rate between the currencies used in those countries.

    Why it may not work: in addition to the reasons you cite above, perhaps the price differential can be explained by the fact that PPP only accounts goods and transferable services.

    Simple labor, for instance, may not be thought of as transferable due to the time, money, and effort required to transfer people en mass from one country (or one economy) to another.

    For instance, the Euro may hurt some nations because PPP does not hold, even across close neighbors. Why? Because even though the European Union provides great trade opportunity and relative ease of travel, language barriers still exist that may be thought of as a high cost to the transportation of workers from one economy to another.

    Also, some services are not transferable. How do you trade haircuts across national borders, for instance.

    Just food for thought.

    ReplyDelete