# Purchasing Power Parity

Continuing the international theme, we are going to talk about Purchasing Power Parity today on MBA Mondays. I learned about purchasing power parity in business school and it has always helped think about international exchange rates. The theory is far from perfect and fails miserably in many situations, but I still think the basic construct of purchasing power parity is something everyone in business should understand.

The basic concept is this: a basket of goods that are traded between markets should cost the same in different markets. My favorite example is the "Big Mac Index" which is calculated and published annually by The Economist. If a Big Mac costs \$4 in the US and 3 pounds in the UK, then the proper exchange rate between the two currencies should be four dollars to three pounds which works out to be 1.33 dollars per pound.

The reason I like the Big Mac index is it is simple to understand. A Big Mac is not a "basket of goods" however and a more comprehensive basket of goods is normally used to calculate purchasing power parity of different countries.

That said, I will use the Big Mac index one more time to explain how purchasing power parity can be used to determine of a currency is overvalued or undervalued. This example comes from wikipedia:

Using figures in July 2008:

• the price of a Big Mac was \$3.57 in the US
• the price of a Big Mac was £2.29 in the United Kingdom (Britain) (Varies by region)
• the implied purchasing power parity was \$1.56 to £1, that is \$3.57/£2.29 = 1.56
• this compares with an actual exchange rate of \$2.00 to £1 at the time
• [(1.56-2.00)/2.00]*100= -22%
• the pound was thus overvalued against the dollar by 22%

This is important to understand. If two baskets of goods should cost the same in different markets and they don't, then the implication is that one currency is overvalued relative to another and that difference will eventually unwind itself.

Let's look at China versus the US. The International Monetary Fund (IMF) estimated in 2008 that one US dollar was worth 3.8 yuan using purchasing power parity. And yet the official exchange rate at that time was one dollar for 7 yuan. That situation has not changed much. The yuan dollar exchange rate is now one dollar of 6.8 yuan.

What this means is that US made goods are more expensive in China than they should be using purchasing power parity as a guide. And Chinese goods are less expensive in the US than they should be using purchasing power parity as a guide. If the dollar yuan exchange rate was allowed to move entirely with market forces, the theory of purchasing power parity says that the exchange rate should move to around 4 yuan to the dollar. Until that happens, this price discrepancy will remain.

There are all sorts of problems with purchasing power parity but I will not go into them here. The basic concept makes sense to me and is used widely in international economics. It is worth understanding as it provides a basic framework for how currencies can and should move relatively to each other.

1. GiordanoBC

Hi Fred,using PPP between China and US is tricky, as you would need to consider additional macro and micro economic factors, but mostly on account of the fact that purchasing power changes dramatically (we’re talking about 5x in some cases) between tier 1 cities and other regions of China: for example, average salaries in Shanghai are up to 10x average salaries in Western ChinaBut, apart from that, not even the US government is arguing for a 4/1 RMB/USD exchange rate, which would mean much higher prices on a vast array of goods, and ultimately the inability to afford them for the average American. Not saying that the Rembimbi is not undervalued, but a massive devaluation of the US dollar would bring chaos and disrupt international trade. Letting it evaluate over the next few years looks like a more feasible policy.Cheers, Giordano

1. fredwilson

Yes, I agree with all of this, particularly how the undervaluation of the yuan should be unwound. Nobody benefits from the carnage that an immediate revaluation would create. But we do need to start moving in that direction

1. RichardF

It seems like a vicious circle that will be hard to break at the moment. The Chinese buy US treasuries which funds the current US stimulus package that funds US jobs that then pay for cheap Chinese products, employing Chinese workers.Any meaningful devaluation is going to cause pain that neither the US or Chinese government particularly want.My feeling is at some point everyone is going to have to start supporting their local markets a bit more (where possible), I wish we would in the UK.

1. fredwilson

Obama and his team know this vicious cycle must be broken. But having the political will to do it is another thing

2. andyswan

You lost me at “US stimulus package that funds US jobs”….You can “stimulate” with as many slush-funds as you want….no one with any sense is going to hire until the outlook for taxation and carbon tax bullshit is clear. We’re facing the largest tax increase in US history in January (funny how those Bush “tax cuts for the rich” don’t seem so one-sided as they are set to EXPIRE….)….and the possibility of a lame-duck congress that will crush industry to make sure the glaciers reverse their 100 century receding trend ASAP…..and a new health care scam that makes anyone and everyone responsible for an individual’s health-care budgeting, save the individual.It’s NOT a good time to be an employer….and I see more and more companies everyday turn to “independent contractors” and outsourcing as a result.The markets are telling us the debt and deficit are fine….it’s the former spend-crazy GOPers screaming and distracting there. The real problem is that there is an abject war on business and war on productivity underway.

1. JLM

It has become an accepted fact that there is no hiring going on in America today.

2. fredwilson

I know our portfolio is a very very very tiny part of the us economy but our portfolio companies are hiring like crazy. I bet those 30 companies added between 1000 and 2000 jobs in the last 12 months

3. Olivier Travers

Are your portfolio funds funded by their account receivables by now, or are they still on VC life support? In the former case the main driver being hiring more staff is serious prospects for within-reach top-line growth.

4. Mark Essel

I should have caught that.1) China buys US treasuries2) US stimulus package bails out failed businesses3) ? see underpants gnomes4) funds US jobs5) pays for cheap chinese products

2. GiordanoBC

Another thing: in the burger example above, more accurate would be to use adjusted purchasing parity, which takes into consideration the main (but not all) externalities such as cost of wages, transportation, taxes etc, which naturally differ by country

1. fredwilson

I hope everyone reads the comments. So much good follow up material here

3. JLM

When you have 2.3-2.7 billion mouths to feed, you are not going to be worried by the accuracy of your foreign exchange rates.

2. Julien

There is ont missing piece here I’d say : the perceived value by the consumer, and since, we’re in a “market economy”, the pricing is determined more by the buyer/seller ratio than by the actual COGS.Another conclusion of all this could be that Brits’ value BigMac 22% more than americans!

1. RichardF

Ha ha – That’s funny JulienBut actually the real reason, I believe, is that there is less fast food competition on the high street in the UK.

1. Julien

Indeed… My point was that purchasing power is actually a lot more of a cultural value than what we may think.

1. Mark Essel

I think Fred aluded to this when he mentioned it’s much more complicated.What about for commodities, you’d think the slim profit margins would have to reflect the purchasing parity.

3. William Mougayar

The labor arbitrage implications are profound for startups that wish to use lower cost locations to provision some services. The issue is quality and availability which are scarce.

1. fredwilson

I think at least half of our portfolio does at least some of that. The most common resources they seek to obtain in lower cost regions are software development, QA, data cleansing, and customer support

1. William Mougayar

That makes a lot of sense. I have that same approach built into our growth plan. It does change the budget numbers favorably.

2. Mark Essel

Related question, how many jobs are created locally versus other nations?

1. fredwilson

In our portfolio? I suspect it is 80pcnt US. Maybe higher

2. riemannzeta

Don’t forget that this “arbitrage” disappears when the peg is removed — which it has been; the Chinese have already loosened it and announced their plans to let it continue to loosen.

1. andyswan

It’s not always a “peg” that allows for arbitrage. Most of the time, it’s supply and demand.In India, there are more capable technology developers than capital, business formations and consumers. Therefore, in India, technology development labor is “cheap” for US capital to employ, even though those developers make a good living in their home country.

1. JLM

Brilliant comment. Agree completely.This also shows how powerful the Internet is as a highway to be able to transport intellectual labor and property across geography.Thank you, Al Gore, you frisky sex crazed wabbit.This is also going to become a strategy to avoid the regulatory and tax implications of American labor as a component of any product or service.

2. William Mougayar

No it won’t disappear. China and India and other low-cost locations are still very cheap for their labor costs,- with or without a peg.

1. riemannzeta

Over the short-term, sure. But over the long-term, the marginal cost of adding a job should balance, all else equal.

1. William Mougayar

In theory yes, but reality no. There will always be lower cost locations around the world, and labor costs are only a part of the factor that comes into play.

4. ShanaC

Other basic thing it means- money is really a stand in for a value of a good or a service. In theory, arbitrage should not be allowed to happen- arbitrage happens because we all make mistakes and quality varies.

5. Mark Essel

Does purchasing parity rely on intrinsic value. I would suspect perceived value to jump all over but the profit margin for Micky Ds to run at to be pretty flat. Maybe burgers cost a little more due to bottom lines in the US and monetary exchange.This whole business about fluctuating currency value is strange. But it makes a little more sense when I consider it’s not just the currency value that’s jumping all around, it’s the cost and prices charged that make downstream products more or less expensive. So the burger changes in cost, and this may impact prices (for commodities it has to).

1. fredwilson

I am not sure I’m qualified to answer that question. We need an economics person to weigh in

6. johndodds

I’ve always felt it would be more watertight if it were the generic (read commodity) burger index. That way you exclude the nolse of cultural differences and concomitant marketing premiums.

1. fredwilson

Good point

2. Fernando Gutierrez

That’s why it makes more sense to use the basket of goods approach, even being more complex. I’ve always though about the Big Mac index as a curiosity or a tool to explain the concept (as Fred’s done here), not something to be taken too seriously.

7. kagilandam

A good measure of finished product should be profit margin*mycurrency. As a producer one should not mind all these as long as he is making the same profit everywhere. Same Mac may cost 2\$ in India because the production labor cost is less….McDon should be happy if he makes the same 1\$ profit margin across various countries and should worry less about what is the selling price…. Am i blah blahing the obvious!!

8. GiordanoBC

Looking at it from a global macroeconomic level, naturally, there s no reason why a job in the US is more important than a job in China, unless it creates enough other jobs globally to make it so. The relation is actually 1 to X>1, since job creation in China is still cheaper and production pro capita is much lower. As such, up until a point in which the marginal benefit of a job lost in the US outweighs that of the jobs created overseas, it can’t be said that the current situation is damaging to global interests. That might well already be the case (and I suspect it is), but there s a lack of convincing data on the issue. Every discussion on this is colored by nationalisticoint of views, which do no good. On the long term, naturally, US citizens will need to adapt to much lower standards of living, while developing countries’ will rise. This is, overall, probably a good thing.

1. JLM

When comparing the currencies of different nations, it is very difficult to prevent more than a bit of “nationalism” from creeping in after all we are talking about comparisons, right?PPP is only one tool in what should be a toolbox of other tools.The concept that US citizens “…will need to adapt to much lower standards of living…” is simply untrue.The challenge in America continues to be to raise an increasingly higher percentage of Americans above some recognizable standard of living of their parents while continuing to provide upward mobility for all who are willing to work toward it.The top segments of American society cannot possibly live any better and thus the battle is being fought at the bottom edge of the middle class and at the poverty level.We are not talking about moving the standards upward but increasing the number of citizens who are above the line of “comfort”.That can be done but it cannot and will not be done through redistributive policies.The very best thing for the entire world is a strong America unless the rest of the world is interested in picking up its own defense tab.

1. andyswan

….and innovation tabs (esp healthcare)

2. ShanaC

JLM- I bet in 100 years we won’t recognize the world. Again.

3. Ardririanto

The long going gap of PPP between the developed and underdeveloped countries simply explain still a heritage product of post western colonialization.

1. JLM

If your post were just a bit more clear it would approach indecipherability. Thanks.

9. andyswan

I like the PPP for its simplicity and ease of understanding. It’s a good tool to teach with and this is a really good post on the subject. Unfortunately, like most teaching tools, it fails in the world of reality (yes, tenured ivy league professors that couldn’t run a lemonade stand, I’m talking to you…)The problem is that the entire currency market is one big PPP experiment. Every second of every day, individuals, corporations and countries are trading one currency for another with the belief that it will bring them more purchasing power for the “basket of goods” that they actually want to purchase.It’s the height of arrogance to believe that you can select the basket of goods that is the true indicator, and that IT will tell you how the billions of dollars trading hands for real-life transactions are pricing things incorrectly.

1. Mark Essel

But there’s a difference. The billions of dollars trading hands are just that, dollars. The basket is something concrete, not a representation of value. It’s worth is relative, but real.My whacked view:Cash is the quantum mechanics representation of value. Cash represents a probability density function of value that is collapsed down and measured only in transactions that purchase real things (labor, goods, pet rocks). Until then it’s just a pipeline, api or symbol for transactions.Cash rich folks desperately try to find places to put their money to maximize growth, putting money to work, etc. As a placeholder it doesn’t do much but provide a safety net or contingency fund (BigCos love the fat cash nets, but if they’re stable they should be dispersing this cash to investors as dividends).

1. andyswan

Ehhhh but those “dollars” represent the buying power of a basket of goods in the end. They don’t move to euros because euros are pretty, they move to euros because they believe that they will need less euros to purchase their own basket of goods/services in the future.

2. riemannzeta

Very interesting, Mark. I have had something like that idea of cash percolating for a while, but I wouldn’t have put it that way.Aside from its high dimensionality, which permits for the “collapse” into particular values in transactions, there is another way in which cash is like probability density functions in QM, or at least those that solve time-dependent Schrodinger equations — namely, the fact that time and cash do not commute. This is the essence of the theory of net present value.

1. Mark Essel

Net present value is estimating current value given future cash flows right (MBA mondays Fred hit on it here)? Time value of money, so you discount future cash flows back to current dollar values and then simply take the difference between income and cost in dollars now (cash flows, inflation, and risk)non-commutable-> time and cash are both operators where order matters. heh, groovy model.

2. fredwilson

I agree andy

3. ShanaC

Actually more interesting is substitutions and its effects in PPP. Hamburgers are not the same as chicken, folks.

10. Brendan

I like the Big Mac index, because I think it’s a clever attempt to tackle a tricky challenge.But it neglects that a big mac in one location (even within a country) is not the same product as a big mac in another. One may be a big mac in central paddington station in London, another off a highway in northern Scotland. The product, to me, contains all of the distribution/convenience effects as well.So I don’t actually see a big mac as a completely comparable product.B

1. MH

or…One could argue that the Big Mac in the UK would be undervalued.

1. andyswan

McD’s fries are ALWAYS undervalued.

11. JLM

I am a huge, huge, huge fan of PPP as a means of evaluating the relative currencies (and for that matter, economies) of different countries — as a check on the indications of published exchange rates. In particular where there are big differences in the nature of the economy (e.g. Afghanistan’s almost total dependence upon the opium poppy) and, say — population (e.g. China).The sensitivity of PPP can be adjusted by any of the many suggestions in this line of comments but it is a clear indicator in its crudest form when it pegs the comparison as being above, below or on the published rates.The whole key to PPP is the “basket” of goods and services used to create the comparison.The inclusion of “labor” is a source of great concern as the compensation, payroll taxes, benefits, tax rates, etc make it very difficult to accurately price this component. This is why I prefer to look at service which incorporate labor absent its many intricacies (e.g. the cost to get a car washed).

12. Druce

Possibly worth pointing out that one should only expect PPP to apply to goods that can be freely imported and exported. In this case the country in which they were underpriced would start exporting them, decreasing supply in the exporting country and increasing it in the importing country until prices were the same, modulo shipping/transaction costs.If there are trade barriers, or items that cannot be easily traded, such as labor, one would not expect to PPP to apply in those cases.Suppose trade is relatively free, and yet PPP is not observed, what does that mean? Every trade flow is a corresponding capital flow – you buy a Honda, you give a Japanese company dollars. So the equilibrium exchange rate keeps US demand for Japanese goods (current account) in balance with Japanese demand for dollar assets (capital account). Countries that experience capital inflows (due to interest rate policies or markets perceiving them as offering good investment opportunities) will have stronger currencies, and PPP might not apply. Greg Mankiw had a good column this weekend on the ‘trilemma’ – open capital markets, flexible monetary policy, stable exchange rate: pick any two – http://www.nytimes.com/2010/07/11/business/econ

1. ShanaC

He wrote up one of the best explanations on PPP for undergraduates in recent years…love that textbook. I have no idea why I like it so much either. Good style…

2. fredwilson

the “trilemma”that’s a great name for an interesting concept

13. Cpdix

Good Stuff by all, and I agree that PPP is a terrific snap shot of a current condition with the appropriate inputs. That said to me the larger issue is the old Ricardian argument of competitive advantage and how price moves relative to that competitive value, suggesting that the issue for a company is to optimise their inputs relative to the values that can be realized in an individual territory – seeking development skills in Bangalore and rent in outlying parts of New York, or SF, or tax efficent warehouses funded by development bonds. As Wayne Gresky said, the key is to skate to where the puck is gonna be, not where it is.

14. paramendra

The PPP also means some countries are not as poor as their dollar based poverty levels might indicate.

15. andrewscott5

AA

16. andrewscott5

Wait a minute! Whoa whoa whoa….WHOA! The U.S. Dollar actually has purchasing power? I thought we would have a KFC Chicken sandwich as PPP, judging how Americans are so fat nowadays!

17. nike

One of the HUGE problems with using PPP for something like RETAIL goods, is that RETAIL goods in comparisson to commdities, bank yields, corporate and government BOND prices and yields, RETAILS GOODs pricing VERY VERY RARELY fluctuate to the downside, or even down WITHIN a countries markets. Companies will do everything to maintain pricing POWER at the retail level, even taking the currency hit (if indeed there is a large enough and LONG enough disconnect) if the currency exchange rates change dramatically. Additionally, we RARELY have say a permanent RE-ADJUSTMENT to currency exchange rates like we are having right now with the Chinese Renminbi. The last time that I can think of where we had an essentially overnight SHIFT and readjustment of exchange rates was when additional countries came into the EU. This was AFTER currency “union” which occurred in the early 90’s. End of 90’s and early 2000’s as additional members shifted to the euro. There were some NICE arbs available at those times.

18. ColumbusKatze

Mr. Wilson: Dang nab it, but your “math” needs work. The correct calculation is:\$2.00/\$1.56 = 1.282… Thus, the Brit Pound was overvalued by approx. 28% compared to the USD.

1. fredwilson

that means wikipedia’s math needs workyou can correct it because it is wikipedia

19. Logan Zane

I was actually looking for this resource a few weeks back. Thanks for sharing with us your wisdom.This will absolutely going to help me in my projects .Ugg Classic Argyle Knit Boots

20. Venkat

Hmm… international yes, but off the ‘risk management’ theme you’ve been developing. I’d like to see the dots connected to entrepreneurial decision-making. The only connection I can think of is on the cost side, you want to use PPP as the basis for compensation for internationally distributed teams.I’d also like to see your list of the top 3-4 ways PPP fails. Since it is primarily used in contexts like cost-of-living/quality of life comparisons at the individual level, and in pricing/sizing/inventory strategies in business, maybe list the issues applying PPP in those contexts?I have my own list of top cautions in using PPP, I’d like to see others’

21. Jerome Camblain

Online business accelerates the move to parity, or at least accelerates the access to new exchange rate benefits.I explain: In just 3 months, the USD strengthened vs Euro. The american tourists are now all over Europe (Fred is in Italy!). US tourists can now reap the benefit of a weaker euro instantly by seing the price adjusted in USD to a lower level on the online offers of the major Travel website. Prior to the online business, they would buy in USD their Europe trip at the same price, fixed for the year in the paper brochure, whatever exchange rate move occur. Online business contributes to a faster move of goods and people (tourists) and should become a currency stabilization force.

1. nike

Sorry, but I have to disagree here. the online impact is TINY compared to any of the things that actually have a currency impact – think commodities, gold, oil, grain, steel, etc.. TINY.A short term move in currency rates does not immediately affect tourism at this point, these are long term considerations (much more so than three months at least) while it may be of benefit to the peripatetic traveller, it isn’t going to drive ad-hoc adoption from anyone on the fence. The currency fluctuations are going to yield such a TINY amount of in country savings as the be irrelevant.Pricing at the retail level isn’t changing and a 5% move in cross currency rates isn’t going to drive purchasing by a foreigner in country.While I think that online business creates COMPETITION, it doesn’t translate across geographic regions. Within europe might be one thing, but since their currencies are all tied together (via Euro) or fixed rates this will only be normal competitive factors and not anything currency related. At the point of consider INTERNATIONAL distribution for an online purchase – the relative cost of transportation (and currency ACQUISITION COSTS – think Credit Card fees, or foreign service charges) would make any short term price disparity totally moot

1. Jerome Camblain

Just ask a French hotel manager. This is a fact, not an idea.

22. andyidsinga

I really love these kinds of posts. Thanks Fred!

23. Lashio212

PPP is a major component of competitiveness and having just spent a few months in Asia my intuition tells me that while anomolies surely exist the divergences are getting smaller and US firms are potentially more competitive there than they realize. To test that hunch I have been hoping to find some data comparing the Big Mac Index over time. Is there a trend? ie is \$ overvaluation getting smaller? If anyone has it or any data on this please let me know.

24. ShanaC

Can you elaborate on it- there have been a number going on, and they are extremely interesting both on a political level and on “how does money work” level