Why Does a Big Mac Cost a Lot Less in China? about:reader?url=https://www.thebalance.com/purchasing-power-parity-...

thebalance.com

Why Does a Big Mac Cost a Lot Less

in China?
By Kimberly Amadeo

Definition: Purchasing power parity (PPP) is an economic theory

that states residents of one country should be able to buy the goods
and services at the same price as inhabitants of any other nation
over time.

Why do economists say that? International trade allows people to

shop around for the best price. Given enough time, everyone's
purchasing power will become equal, or reach parity. PPP depends
on the law of one price.

That states that once the difference in exchange rates is accounted

for, then everything would cost the same. (Source: Journal of
Economic Literature, Kenneth Rogoff, Purchasing Power Parity
Puzzle, June 1996)

That's not true in the real world on a day-to-day basis. That's

because of differences in transportation costs, taxes, and tariffs.
Some things, such as land and services (like haircuts), can't be
shipped. Not everyone throughout the world has the same access to
international trade. For example, someone in rural China can't
choose between every good and service throughout the world.

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Perhaps one day Amazon.com and other online retailers will enable
real purchasing power parity.

PPP Calculation

Purchasing power parity is a calculation that determines how much

things would cost if parity did exist. It takes into account the impact
of exchange rates. It describes what each item purchased in a
country would cost if it were sold in the United States.

These are then added up for all the final goods and services
produced in that country for that given year.

Parity is tedious to compute. A U.S. dollar value must be assigned to

everything. That includes items not widely available in America.
For example, there aren't too many ox-carts in the United States.

Would its U.S. price accurately describe its value in rural Vietnam,
where it's needed to grow rice?What is the U.S. price equivalent of a
haircut in a country where family members give it?

For many developing countries, the PPP is estimated using just a

multiple of the official exchange rate (OER) measure. For
developed countries, the OER and PPP measures of GDP are more
similar, since their standards of living are closer to the United
States.

How It's Used

Purchasing power parity is used in many situations. The most

common method is to adjust for the price differences between

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countries. For example, China produced $10.98 trillion in goods

and services in 2015. The U.S. produced $17.95 trillion. But you
cannot compare the two without taking into account the fact that
the cost of living in China is much lower than in the United States.

For example, a McDonald's Big Mac costs $5.04. In China, you can
get the same thing for only $2.79. People in China don't need as
much income because it costs less to live. (For more fun
comparisons, see The Economist's Big Mac Index)

That's because China artificially sets the value of its currency to be

lower than the U.S. dollar. It intentionally wants its cost of living to
be lower, so it can pay its workers less.

As a result, its exports cost less, making it more competitive on the

global market. For more, see Currency Wars.

Purchasing power parity solves the problem of comparing countries

with different standards of living. It recalculates the value of a
country's goods and services as if they were being sold at U.S.
prices. Under PPP, a Chinese Big Mac costs $5.04, the same as it
does in the United States. As a result, China's GDP under PPP is
$19.39 trillion. That makes it the world's largest economy, ahead of
the European Union and the United States. That's why the CIA
provides GDP estimates on both an official exchange rate and a
purchasing power parity basis.

Without purchasing power parity, China's GDP per capita would

only be around $6,475. That's lower than the standard of living in
Ukraine, Algeria or Kosovo.

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With PPP, each of the 1.3 trillion people receives (on average) the
benefit of $14,100 in economic production. That's better, but still
only on the level of Libya and worse than Iraq. It's far less than the
U.S. GDP per capita of $55,800. That's because the United States
divides its GDP among only 319 million people. (Source: CIA
Factbook)

Although this doesn't happen often, PPP is also used to set the
exchange rate for new countries. It is used to forecast future real
exchange rates.

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