Despite increasing global economic integration, there continue to be large and
persistent differences between countries in the prices of many otherwise identical
products. Research by Professors David Parsley and Shang-Jin Wei, published in the
October 2007 issue of the Economic Journal, addresses this puzzle by examining the
prices of a Big Mac and its ingredients.
They find that the impact of non-traded components of Big Mac prices (labour,
marketing, distribution, rent, utilities, etc.) account for much of the persistence in
international price differences. Intuitively, this is because final products contain so much
local content, which is inherently non-traded – at least 55% in the case of a Big Mac.
The study also concludes that the use of aggregate price indices masks convergence in
individual prices. This suggests that comparing national price indices is misleading
because of cross-country differences in the price indices themselves – for example,
different relative weights for rice and cheese in Japan compared with France.
Price differences represent potential economic inefficiencies and/or missed arbitrage
opportunities. International price differences also convey information about purchasing
power between countries. ‘Purchasing power parity’ (PPP) occurs when the prices of
the same bundle of consumption goods in two countries are equal, when expressed in
a common currency.
Even though most people at one time or another have observed international price
differences, for example when they travel abroad, such data are of little help in rigorous
tests of the various explanations. For that one needs many such observations (data
points) collected over time, and statistical analysis.
Unfortunately, the national agencies that collect price data disguise them by averaging
individual prices into a consumer price index (CPI) prior to public dissemination, mainly
to protect the anonymity of the vendors supplying the underlying prices. Nearly all we
know about international price differences comes from statistical analysis of CPI data.
Economists have identified many shortcomings of CPIs for addressing questions about
the causes of observed price differences. First, since price indices are simply price
averages expressed relative to a base year, the exact magnitude of international price
differences cannot be ascertained by comparing national CPIs.
There are other problems with CPIs, limiting their usefulness for studying these
questions. For example, the Japanese CPI puts a bigger weight on rice than the French
one, making the two price indices less comparable.
Big Mac prices have several advantages over CPIs. First, since the Big Mac is
standardised across countries and its actual prices are observed, one can meaningfully
study price differences of identical items across countries. Using the time series history
of these prices this study shows that Big Mac prices are highly correlated with national
price levels (thus are not so narrow as to be uninformative).
Finally, the study matches Big Mac prices with the prices of its underlying ingredients
(since the exact composition of a Big Mac is known) and thus is able to make
inferences about how much non-traded factors (labour, rent, utilities, etc.) versus how
much traded factors contribute to the overall PPP puzzles.
The research finds that:
• Deviations from price parity actually disappear fairly quickly for identical goods,
in contrast to evidence from consumer price indices.
• The results from unbundling the Big Mac into its traded and non-traded
ingredients reveals that deviations from price parity for identical, highly tradeable
products accounts for only a small portion of overall international price
differences, again in contrast to evidence from consumer price indices.
• Final goods prices embody a considerable portion (at least 55%) of non-traded
inputs. Thus, movements in labour and other non-tradeable items prices can be
a central factor in determining the size and persistence of international price
differences (a much more intuitive result).
• Greater exchange rate variability increases international price deviations since
price deviations in traded inputs become more important with higher exchange
rate volatility.
ENDS
Notes for editors: ‘A Prism into the PPP Puzzles: The Micro-foundations of Big Mac
Real Exchange Rates’ by David Parsley and Shang-Jin Wei is published in the October
2007 issue of the Economic Journal.
David Parsley is at Owen Graduate School, Vanderbilt University, Nashville. Shang-Jin
Wei is at Columbia University.
For further information: contact David Parsley on +1-615-322-0649 (email:
dparsley@owen.vanderbilt.edu); or Romesh Vaitilingam on 07768-661095 (email:
romesh@compuserve.com).