Law of One Price and Purchasing Power Parity
The modern context of the world economy accounts for significant varieties in the standards of living and economic stability across the world. The currency exchange rates and inflation demonstrate some evident disparities in the states’ economics and stability. Hence, while it would be reasonable to assume that the costs for goods will differ significantly in the US and Uruguay due to the countries’ economic status. For example, while the net national income per capita of Uruguay constitutes approximately 23% of the US net national income per capita, the prices for such a commodity as iPhone should be different in these countries (World Bank, 2021). However, while iPhone 12 would cost approximately two monthly salaries for an average Uruguay resident, with the same phone constituting nearly 30% of the US monthly salary, the cost of this commodity will still be the same in the two states.
Such regularity is known as the Law of One Price, and it states that the price of a good in one country should be the same for an identical good in another country (Pierdzioch et al., 2021). Apart from the convenience of international trade, this law also aims at preventing market challenges of buying goods for lower prices and selling them for higher prices to different countries. This phenomenon is closely related to the idea of purchasing power (PP) of individuals or the number of goods and services they can buy for a unit of currency (Cherunilam, 2020). Hence, once the prices across states are different, the PP also differs, disrupting the world economy and prospects of international trade.
In order to eliminate this issue, the concept of purchasing power parity (PPP) was established, meaning that one’s income should have the same PP in different countries (Cherunilam, 2020). In other words, the currency exchange rates should be regulated so that the basket of products would cost the same in different states. Hence, both the law of one price and PPP were created for the sake of proper nominal exchange and regulation of prices across the national economies.
PPP Empirical Evidence
In order to define the validity of PPP as an economic concept, it is necessary to look into the existing currency relationships and their purchasing power. Over the past decades, researchers have recognized the validity of the so-called ‘Big Mac Index’ as a PPP practical test. Having introduced the index back in 1986, The Economist editors took a McDonald’s Big Mac, the product existing in the majority of national economies, and compared the nominal exchange rates in relation to the US dollar as a base currency for a commodity (Reinert, 2020). Hence, for the sake of comparison, the first set of bilateral nominal exchange rates will use Big Mac Index as a ground for comparison.
For example, if to compare the US and Russia as some of the biggest countries in the world, the price of one Big Mac in Russia is 59.9% less than in the US (The Economist, 2021). According to the law of one price, Big Mac in Russia should cost 421 rubles instead of the current price of 169 rubles. However, apart from the raw index, it is necessary to take into account the GDP per capita in each country in order to make sure that the purchasing power is the same. Thus, according to a GDP-based index, instead of costing 59.9% less, a Big Mac in Russia should cost 38.9% less, making the implied PPP approximately $3.44 (The Economist, 2021). It becomes evident from this example that in the case of the nominal exchange rate between Russia and the US, the PPP does not quite hold, and such a disparity may be caused by a variety of external reasons, including political implications and lack of information exchange between the states.
Another set of bilateral nominal exchange rates concerns the continuation of an iPhone price PPP between the US and Uruguay. Hence, while the approximate cost of an iPhone 12 256 GB in the US is $880, in Uruguay, it is nearly 40,000 Uruguay pesos, or $908. Based on the idea of absolute PPP, the cost of the commodity in Uruguay should also be $880, or 38,600 Uruguay pesos. However, this assumption does not hold due to the fact that absolute PPP does not account for transportation costs and taxation policies (Cherunilam, 2020). Since, in both cases, the commodity shipment would be from Apple’s subsidiaries in China, it would be reasonable to assume that the good’s price in Uruguay would be higher due to higher shipment charges.
Factors Explaining PPP Performance
Although the implementation of PPP is a challenging and sometimes questionable endeavor, the examples above demonstrate that it is an absolute necessity when it comes to world economy patterns and international trade. For example, when looking at the first example, the implied PPP helps regulate the local residents’ purchasing power. Once the real exchange rate is employed, the amount of $5.65 worth of one Big Mac would have a completely different purchasing price in Russia, with fast food having almost the same cost as a restaurant dish. In this case, a lower price in terms of implied PPP is not a threat to the international economy, as it would not be profitable to export $3.44 Russian Big Macs to the US, as the commodity would lose its purchasing value.
On the other hand, when looking at the example of iPhones, it is evident that lowering iPhone prices according to Uruguay’s GDP would create a severe discrepancy in the market. Retailers would buy this commodity at a lower price in Uruguay and resell it in other countries for the sake of profit. For this reason, such concepts as geography, levels of economic inequality, transportation, and market policies, are some of the many factors that contribute to PPP performance.
Reference List
Cherunilam, F. (2020) International economics (6th edition). McGraw-Hill Education.
Market share of grocery stores in Great Britain from January 2017 to May 2021. Web.
Pierdzioch, C., Schöber, T. and Stadtmann, G. (2021) Law of one price: BigMac versus Fortnite-A note (No. 421). Discussion Paper.
The Economist (2021) The Big Mac index. Web.
World Bank (2021) Adjusted net national income per capita (current US$). Web.