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The article titled “Burgernomics: A Big Mac Guide to Purchasing power parity” was written by Michael R. Pakko and Patricia S. Pollard in 1996. Its current version, with some edits and insights from Heidi Beyer, was published in 2003. As the name of the article suggests, it addresses the accuracy of the so-called Big Mac index – an index used as a simplified application of the Purchasing power parity theory in many publicist works and journals. While the Big Mac and its components might serve as a simplified “market basket,” which is often implemented in sociological analyses when it comes to minimum wages and labor, it does not hold up to scrutiny and cannot be used as a palatable measure of the PPP (Pakko & Pollard 2003).
The Law of one price
The article begins with how the law of one price relates to the PPP. It states that any product sold anywhere in the world would be sold at approximately the same price if it was transferred into a common currency. It is rationalized that if in one part of the world a product or a resource is sold much cheaper than in the rest of the world, then the markets would purchase that resource until they are full, thus restoring the equilibrium. This process is known as arbitrage PPP (Pakko & Pollard 2003).
The Absolute PPP
Next, the authors are getting the audience acquainted with the concept of absolute PPP and its connection to the PWT dataset. The idea is that since all the goods that a Big Mac consists of are present and available on the global market, it means that the Law of one price should apply to it. However, when analyzing the results provided by The Economist in a period between 1986 – 2003, it is easy to notice that in the majority of the cases, the Big Mac index deviates from the PPP index by quite a considerable amount. Out of 481 individual observations, only 26.6 percent of results showed a standard deviation of less than 10 percent from the PPP index for the individual goods PPP (Pakko & Pollard 2003). After analyzing the deviations in the Big Mac Index about the currencies in different countries at the time of the study, the researchers found that the deviations from PPP are temporary and that the adjustments towards the PPP usually take place in exchange rates and goods prices.
The Relative PPP
After investigating the Big Mac index and how it relates to the absolute PPP, the authors move on to the relative PPP index. The article states that for the Law of one price to work about the PPP, the weights assigned to the goods in the price indices must be the same across countries PPP (Pakko & Pollard 2003). Relative PPP is reliant not only on the prices for the goods worldwide but also on the rates of consumption of said goods in particular countries. Although many types of research are based on relative PPP, the article states that the data on relative PPP cannot be used for comparison with the Big Mac Index because the available data on the subject is insufficient. In short, it is unclear where the deviations from absolute or relative PPP come from, as in both scenarios the Big Mac index seemed to differ from the given norm my a significantly large margin PPP (Pakko & Pollard 2003).
Why Does the Big Mac Fail?
Afterward, the authors try to understand the reasons why the Big Mac index differs from the PPP index. They underline three large factors that contribute to the dilemma. These factors are PPP (Pakko & Pollard 2003):
- Barriers to Trade
- Non-traded elements
- The market pricing
Barriers to trade are considered to be a major barrier to the perfect Law of one price Equation. They include transportation costs, economic sanctions, and restrictions to protect the local markets, as well as taxes. Depending on the distance between the producers and the markets, shipping from point A to point B could be less profitable than from importing from other, closer markets. Economic sanctions and restrictions also disrupt the free flow of commerce, which is one of the fundamental conditions for the Law of one price to function. Lastly, different tax rates in countries would also affect the end prices of goods that are either imported or produced domestically PPP (Pakko & Pollard 2003).
Another important factor that contributes to the difference between the Big Mac index and the PPP index is the value of non-traded goods involved in its production. One of such non-traded goods is labor spent on producing the Big Mac. Salaries in McDonald’s differ across countries. Moreover, unlike it is with the shipment of products, not all employees can migrate from a country with lower salaries to a country with higher salaries. This creates a discrepancy between expenditures, which affect the overall price of the Big Mac in different countries. Since the product is more than just a sum of its parts, the value of work spent on making it also affects the final price for the end-user. Productivity also plays an important part. The quality of training affects the production speed. The higher it is – the more profitable the product becomes PPP (Pakko & Pollard 2003).
The last factor to affect the Big Mac Price is the pricing to the market. This is a rather obscure factor, as it relates to the immaterial part of the product – the brand and the experience of eating it. While Big Mac in itself is not a product that could be easily transported across different borders, its ingredients are. Therefore, in a free market without any restrictions, the Law of one price should affect it equally, no matter where the product is sold. However, the realities of business rarely adhere to the perfect theoretical model. The views on McDonald’s and the Big Mac differ greatly across the world – in the USA it is viewed as a cheap supplier of unhealthy food, while in China and Korea it is a restaurant and a place to socialize. This reflects on the pricing policy PPP (Pakko & Pollard 2003).
The article concludes that while the PPP model is a useful theoretical model, it cannot be used as a price prediction tool, because it does not account for many factors that go into making a product, such as the brand, the wage differences, the policies and taxes, and the non-tradable goods. Even the Big Mac, which is made out of the simplest and most basic of goods that fit perfectly into the typical market basket, is subjective to this trend, as the process of producing it involves numerous activities subjective to taxes and tariffs, as well as the use of non-tradable goods. Even within the borders of one country, the difference in Big Mac prices differs up to one dollar. The PPP model fails to work normally between different cities of a single country, meaning that the application of the model on a larger scale is impossible.