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Jodi Beggs

Fun with Purchasing-Power Parity: The Big Mac Index

By July 16, 2012

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In a recent article on purchasing-power parity, I explained that various (natural and unnatural) barriers to trade cause the theory of purchasing-power parity (i.e. the notion that a unit of currency can be traded and used to buy the same amount of stuff in any country, or that real exchange rates are equal to 1) to not hold in practice.

Often, the absence of purchasing-power parity is hard to see, since it's likely the case that goods and services in one country aren't completely equivalent to goods and services in another. (In other words, goods in different countries are not always perfect substitutes for one another.) The Economist has gotten around this problem in a creative way, however, with what they call their Big Mac Index. This index compares the price, in US dollars, of a Big Mac (which is roughly the same product in each country, with a few exceptions) in a number of different countries. If purchasing-power parity held, the dollar prices in all of the countries would be the same. Instead, what the creators of the index find is that prices range from $1.62 in India (though this is technically the price of a "Maharaja Mac") to $6.81 in Switzerland. The lack of purchasing-power parity makes sense to some degree, since Big Macs are pretty hard to transport and traveling to another country to pick one up isn't exactly cost effective.

Lack of purchasing-power parity even exists across states in the US, in a way. For example, it's not surprising that a dollar doesn't go as far in the Boston housing market as it goes in the Phoenix housing market, even if the houses themselves are mostly similar. (This is at least partially because it's hard to transport a house from one place to another!) One can even take the purchasing-power parity concept a step further and look at wages versus cost of living, or, put another way, where an hour of your time goes the furthest. (Spoiler alert: it's Houston.)

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