Purchasing power parity (PPP) states that the price of a good in one country is equal to its price in another country after adjusting for the exchange rate between the two countries.

As a light-hearted annual test of PPP, The Economist has tracked the price of McDonald's Big Mac burger in many countries since 1986. This experiment - known as the Big Mac PPP - and similar tests have been underway for decades. Here we take a look at this unique indicator, and find out what the price of the ubiquitous Big Mac in a given country can tell us about its wealth.

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To illustrate PPP, let's assume the U.S. dollar/Mexican peso exchange rate is 1/15 pesos. If the price of a Big Mac in the U.S. is \$3, the price of a Big Mac in Mexico would be 45 pesos assuming the countries have purchasing power parity.

If, however, the price of a Big Mac in Mexico is 60 pesos, Mexican fast-food shop owners could buy Big Macs in the U.S. for \$3, at a cost of 45 pesos, and sell each in Mexico for 60 pesos, making a 15-peso risk-free gain. (Although this is unlikely with hamburgers specifically, the concept applies to other goods as well.)

To exploit this arbitrage, the demand for U.S. Big Macs would drive the U.S. Big Mac price up to \$4, at which point the Mexican fast-food shop owners would have no risk-free gain. This is because it would cost them 60 pesos to buy U.S. Big Macs, which is the same price as in Mexico â€“ thus restoring PPP.

PPP also means there will be parity among prices for the same good in all countries (the law of one price). (To learn more about capitalizing on the relationship between price and liquidity, read our related article Arbitrage Squeezes Profit From Market Inefficiency.)

Currency Value
In the example above, where the Big Mac is at a price of \$3 and 60 pesos, a PPP exchange rate of US\$1 to 20 pesos is implied. The peso is overvalued against the U.S. dollar by 33% (as per the calculation: (20-15)/15), and the dollar is undervalued against the peso by 25% (as per the calculation: (0.05-0.067)/0.067).

In the arbitrage opportunity above, the actions of many Mexican fast-food shop owners selling pesos and buying dollars to exploit the price arbitrage would drive the value of the peso down (depreciate) and the dollar up (appreciate). Of course, the actions of exploiting a Big Mac alone is not sufficient to drive a country's exchange rate up or down, but if applied to all goods - in theory - it might be sufficient to move a country's exchange rate so that price parity is restored.

For example, if the price of goods in Mexico is high relative to the same goods in the U.S., U.S. buyers would favor their domestic goods and shun Mexican goods. This loss of interest would eventually force Mexican sellers to lower the price of their goods until they are at parity with U.S. goods.

Alternately, the Mexican government could allow the peso to depreciate against the dollar, so U.S. buyers pay no more to buy their goods from Mexico. (Read Forces Behind Exchange Rates to learn more about what affects a currencies relative strength.)

Short-Term Vs. Long-Term Parity
Empirical evidence has shown that for many goods and baskets of goods, PPP is not observed in the short term, and there is uncertainty over whether it applies in the long term. Pakko & Pollard cite several confounding factors as to why PPP theory does not line up with reality in their paper "Burgernomics" (2003). The reasons for this differentiation include:

• Transport Costs: Goods that are not available locally will need to be imported, resulting in transport costs. Imported goods will thus sell at a relatively higher price than the same goods available from local sources.

• Taxes: When government sales taxes, such as value-added tax (VAT), are high in one country relative to another, this means goods will sell at a relatively higher price in the high-tax country.

• Government Intervention: Import tariffs add to the price of imported goods. Where these are used to restrict supply, demand rises, causing price of the goods to rise as well. In countries where the same good is unrestricted and abundant, its price will be lower.

Governments that restrict exports will see a good's price rise in importing countries facing a shortage, and fall in exporting countries where its supply is increasing. (To learn how importing and exporting influences currency value, be sure to read Current Account Deficits.)

• Non-Traded Services: The Big Mac's price is composed of input costs that are not traded. Therefore, those costs are unlikely to be at parity internationally. These costs can include the cost of premises, the cost of services such as insurance and heating and especially the cost of labor.

According to PPP, in countries where non-traded service costs are relatively high, goods will be relatively expensive, causing such countries' currencies to be over-valued relative to currencies in countries with low costs of non-traded services.

• Market Competition: Goods might be deliberately priced higher in a country because the company has a competitive advantage over other sellers, either because it has a monopoly or is part of a cartel of companies that manipulate prices.

The company's sought-after brand might allow it to sell at a premium price as well. Conversely, it might take years of offering goods at a reduced price in order to establish a brand and add a premium, especially if there are cultural or political hurdles to overcome.

• Inflation: The rate at which the price of goods (or baskets of goods) is changing in countries, the inflation rate, can indicate the value of those countries' currencies. Such relative PPP overcomes the need for goods to be the same when testing absolute PPP discussed above.

The Bottom Line
PPP dictates that the price of an item in one currency should be the same price in any other currency, based on the currency pair's exchange rate at that time. This relationship often does not hold in reality because of several confounding factors. However, over a period of years, when prices are adjusted for inflation, relative PPP has been seen to hold for some currencies.

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