Purchasing Power Parity Explained
Summary
TLDRThis lesson explains the concept of Purchasing Power Parity (PPP), an economic theory that suggests exchange rates between currencies are balanced when their purchasing power is equal across countries. The lesson covers how PPP can be used to set prices competitively in different markets by considering local economic realities. Using examples like the Big Mac Index and a software company adjusting prices for Chinese and Indian markets, the lesson highlights how PPP can boost sales, increase revenue, and help businesses strategically navigate international markets.
Takeaways
- 💡 Purchasing Power Parity (PPP) explains why the same product costs different amounts in different countries by adjusting for local purchasing power.
- 🔄 PPP is an economic theory that suggests exchange rates between currencies should equalize purchasing power between countries.
- 🛍️ Real exchange rates, which reflect PPP, are preferred by businesses to adjust prices for affordability in different markets.
- 💰 Businesses using PPP can increase sales and revenue by pricing products based on local economic conditions, rather than nominal exchange rates.
- 📉 Nominal exchange rates often fluctuate due to factors like speculation, interest rates, and inflation, which don't always reflect true purchasing power.
- 🧾 A real-world example shows how adjusting prices using PPP in China and India can lead to a significant increase in customers and revenue for businesses.
- 📈 Efficient Soft, a fictional software company, increased revenue in China and India by 500% through PPP pricing adjustments.
- 🍔 The Big Mac Index, developed by The Economist, uses the price of a Big Mac to compare currency values and show whether they are over or undervalued.
- 📊 PPP helps compare economic output and living standards by accounting for inflation differences between countries.
- ⚖️ While PPP is a useful tool for long-term planning and economic analysis, it has limitations, such as distortions caused by tariffs, taxes, and variations in non-tradable services.
Q & A
What is purchasing power parity (PPP)?
-Purchasing power parity (PPP) is an economic theory that suggests that exchange rates between currencies are in equilibrium when their purchasing power is identical in each respective country. It accounts for differences in price levels and purchasing power across nations.
Why do prices for the same products, like a Big Mac or Coca-Cola, differ between countries?
-Prices differ because of variations in purchasing power between countries. PPP explains these differences by accounting for the local economic conditions and real purchasing power, which is influenced by factors such as income levels, inflation, and exchange rates.
How does PPP differ from nominal exchange rates?
-Nominal exchange rates reflect the current market price of one currency relative to another. PPP, however, adjusts for the differences in purchasing power between countries, reflecting the real value of goods and services in each economy.
What are the benefits of using PPP for businesses?
-Using PPP allows businesses to set prices that reflect the local economic reality, making their products more affordable and competitive in different markets. This can lead to increased sales and maximized revenue by pricing products appropriately based on local purchasing power.
Can you explain the concept of an undervalued and overvalued currency using PPP?
-If a currency is undervalued, it means that it holds less purchasing power relative to another currency, so it requires more money to buy the same basket of goods. Conversely, if a currency is overvalued, it holds more purchasing power, allowing you to buy more goods with less money.
How does the example of a US software company illustrate the use of PPP?
-In the example, a US-based software company adjusts its prices in China and India using PPP, reducing the cost of its subscription to reflect local economic conditions. This price adjustment leads to a significant increase in customers and revenue in those markets.
What is the Big Mac Index, and how does it relate to PPP?
-The Big Mac Index, created by The Economist, compares the price of a Big Mac across countries to determine whether currencies are overvalued or undervalued using PPP. It offers a simple way to assess if exchange rates reflect true purchasing power.
What are the advantages of using PPP?
-The advantages of PPP include its simplicity and intuitiveness, the ability to account for inflation differences between countries, and its usefulness for long-term economic planning and decision-making for businesses and policymakers.
What are the disadvantages of using PPP?
-Disadvantages of PPP include external factors like tariffs, taxes, and trade barriers that can distort calculations, the lack of identical goods across markets, and the difficulty of comparing non-tradable services like healthcare and education across countries.
Why is PPP still considered a valuable tool despite its limitations?
-PPP is a valuable tool because it provides insight into cost of living differences across countries, helps businesses and policymakers make informed decisions, and is useful for understanding the real economic value of currencies over the long term.
Outlines
💸 Understanding Purchasing Power Parity (PPP)
The first paragraph introduces the concept of Purchasing Power Parity (PPP), explaining that it accounts for why prices of goods like a Big Mac or Coca-Cola vary between countries. PPP is an economic theory stating that exchange rates between currencies are in equilibrium when their purchasing power is the same in each country. The purpose of PPP is to help level prices across different economies by accounting for real purchasing power, making it useful for businesses aiming to set competitive prices in international markets.
🌐 Practical Application of PPP for Businesses
The second paragraph elaborates on how businesses, using PPP, can adjust their prices to better reflect the local economic realities of different countries. For example, a US-based software company named Efficient Soft adjusts the price of their $100 subscription in China and India using PPP to make their products more affordable and competitive. By halving the price for Chinese consumers, they gain significant market share and increase revenue. This shows how PPP enables businesses to tap into new markets while remaining competitive and profitable.
🍔 The Big Mac Index and Real-World Examples of PPP
In this paragraph, the Big Mac Index is introduced as a real-world example of purchasing power parity. Created by The Economist in 1986, it uses the price of a Big Mac across countries to compare the actual exchange rate with PPP. The index highlights how certain currencies can be over or undervalued, such as the Swiss franc being 43.5% overvalued compared to the US dollar. The Big Mac Index provides a simple way to gauge the real value of currencies and serves as an intuitive tool for understanding PPP.
📈 Pros and Cons of Purchasing Power Parity
This paragraph discusses the advantages and disadvantages of PPP. The advantages include its simplicity, ability to adjust for inflation differences, and its usefulness for long-term economic planning. However, external factors like tariffs and taxes can distort PPP calculations, and differences in non-tradable services, such as healthcare and education, make it challenging to accurately reflect purchasing power across all sectors. Despite these limitations, PPP remains a valuable tool for businesses and policymakers.
🚀 Final Thoughts on the Importance of PPP
The final paragraph summarizes the value of PPP as an analytical tool for understanding cost-of-living differences and making informed decisions in international business. It emphasizes that while PPP has limitations, such as its inability to account for non-tradable goods, it remains an essential tool for businesses looking to price products competitively across different markets. The Efficient Soft example demonstrates how companies can use PPP to maximize revenue and reduce dependence on a single market, thereby ensuring long-term growth and sustainability.
Mindmap
Keywords
💡Purchasing Power Parity (PPP)
💡Nominal Exchange Rate
💡Real Exchange Rate
💡Undervalued Currency
💡Overvalued Currency
💡Big Mac Index
💡Inflation
💡Revenue Maximization
💡Tariffs
💡Strategic Pricing
Highlights
Introduction to Purchasing Power Parity (PPP) with real-world examples of price differences for common goods like a Big Mac and Coca-Cola.
Definition of PPP: An economic theory stating that exchange rates between currencies are in equilibrium when their purchasing power is identical across countries.
Explanation of the nominal exchange rate and how it differs from real exchange rates, using an example of buying a basket of goods in the US and UK.
Real exchange rate (or PPP) demonstrates that currencies may be overvalued or undervalued when their purchasing power differs from the nominal exchange rate.
Using PPP for pricing strategy: How businesses, like EfficientSoft, can adjust their prices to align with local purchasing power in global markets.
Example of EfficientSoft adjusting its subscription price in China and India to account for local purchasing power, increasing revenue by over 500%.
How PPP pricing strategies can help businesses maximize revenue and remain competitive in local markets without sacrificing profitability.
The Big Mac Index: A simple, intuitive measure created by The Economist to compare currency overvaluation and undervaluation based on the price of a Big Mac in various countries.
Advantages of PPP: Provides a framework for comparing economies, accounts for inflation differences, and aids long-term economic planning for businesses and policymakers.
Disadvantages of PPP: External factors like tariffs and trade barriers can distort PPP calculations, and non-tradable services such as healthcare may not be accurately reflected.
Real-world application of PPP: It helps businesses like EfficientSoft price products competitively in international markets and make informed economic decisions.
Summary of how PPP is a useful tool for economic analysis, helping strategists, policymakers, and investors gain insights into currency valuations.
Explanation of how nominal exchange rates fluctuate due to factors like trader speculation, inflation, and changes in interest rates.
Example of undervalued vs overvalued currencies: The US dollar undervalued relative to the UK pound, and how it impacts purchasing power.
Final take: While PPP has limitations, it remains a powerful model for analyzing cost-of-living differences and informing business strategies.
Transcripts
hello and welcome to today's lesson
where we're looking at purchasing power
parity now have you ever wondered why a
Big Mac costs close to $6 in the US
which is $350 in
China or why a can of Coca-Cola costs
about $250 in the US but just 132 in
Mexico well the answer can be explained
by a concept called purchasing power
parity which is a way of leveling prices
across countries to take account of real
purchasing power
so what exactly is purchasing power
parity well it's an economic theory that
posits that the exchange rates between
currencies are in equilibrium when their
purchasing power is identical in each
respective country now if that doesn't
make sense right now don't worry it will
become a lot clearer once we start
working through an
example so why would you use it well in
short you'd use it because it can
increase your revenue and profit using
PPP these businesses can set their
prices to take account of the economic
reality of each country in which they
want to sell their product and that's
going to make their products affordable
and competitive in those local markets
and ultimately rather than reducing
Revenue through reduced prices PPP can
help businesses increase sales and
maximize
Revenue now let's take a look at an
example to make sense of purchasing
power parity imagine that the exchange
rate between the US and UK is6 of a
pound meaning that $1 buys you .6 of a
pound now this exchange rate is known as
the nominal exchange rate and in a
perfect world The nominal exchange rate
would reflect the difference in
purchasing power between the two
currencies now suppose you've bought a
basket of goods in the US that cost you
$1,000 and you want to buy that same
basket of goods in the UK in an Ideal
World your $11,000 basket should cost
£600 in the UK using the nominal
exchange rate but unfortunately we don't
live in an Ideal World and nominal
exchange rates can fluctuate wildly for
all kinds of reasons like Trader
speculation changes in interest rates
inflation expectations Etc and because
they can fluctuate so much they don't
always reflect purchasing power and
that's why economists and businesses
alike prefer to use real exchange rates
and this real exchange rate is also
called the purchasing power parity
between the two countries so now imagine
you actually went to the UK with your
,000 which you converted into £600 using
the nominal exchange rate available to
you and you want to actually buy that
basket of goods in the UK what if you
discovered that it was going to cost you
£800 well in that case case you'd be
£200 short or approximately
$333 short this is the real exchange
rate this is purchasing power parity the
reality of the situation is that you'd
need
$1,333 to buy the equivalent of your
$11,000 basket of goods in the UK so
what we can say is that the real
exchange rate or purchasing power parity
is actually .8 of a pound
and what this means is that the dollar
is undervalued as it's not buying you as
much as you might expect it to an
undervalued dollar means it holds less
purchasing power relative to the pound
and similarly we could say that the
pound is overvalued because an
overvalued pound means that it holds
more purchasing power relative to the
dollar so let's take a look at a real
world example so you can see how
purchasing power parity can benefit a
real
business imagine you run a us-based
software company that develops
productivity tools we're going to call
the company efficient soft and you
charge $100 annually for a subscription
to your product which you sell
online now your primary focus is the US
market but because you sell online you
have customers
worldwide now a simplified breakdown of
your Global sales might look something
like
this and the main things to really note
here are that you charge the same price
$100 in all countries that the US is
your biggest Market both in terms of
number of customers and in terms of
Revenue and China and India you have a
very small number of customers and also
quite a small amount of Revenue your
combined revenue for those two markets
is just
$40,000 so you realize that average
income in China and India is
significantly lower than in the us for
China to dates you've just been using
the nominal currency conversion rate to
charge whatever $100 works out as in
Chinese Yuan and assuming an exchange
rate of Seven Chinese Yuan to one US
dollar that works out as 700 CNY is your
annual price now your research on
average income data and local purchasing
power indicates that this price is
prohibitively expensive for most Chinese
consumers so instead using PPP you
decide to price the subscription at 350
Chinese you ear which is half what you
were previously charging so about
$50 and that's more aligned with the
Local Economic
environment this price adjustment not
only makes the subscription more
affordable for Chinese customers but
also makes you competitive against
Chinese providers of similar
software now you do the same kind of
adjustment for the Indian market using
purchasing power par
and one year later assuming no changes
in the US and UK in terms of sales or
Revenue the results of these changes can
be seen in this table and as you can see
when you're later you've dramatically
increased the number of customers you
have in these territories you you've got
now got 2,000 customers in China and
three and a half thousand in
India and what that means is that you've
gone from 40,000 Revenue previously in
these territories to over
$222,000 in revenue for these two
territories which is an increase of over
500% now without any contribution from
the US or UK you've increased your total
revenue by 12% and finally one last
benefit to you of this change is that
while you're still heavily reliant on
your US market you're now less Reliant
than you were
before now let's take a look at
something called the Big Mac index which
is based upon purchasing power parity
this was created by The Economist in
1986 and the index uses the price of a
Big Mac across different countries to
determine whether currencies are at
their in quotes correct level according
to PPP and they chose to use the Big Mac
for this because it's sold in over 100
countries worldwide and most people know
exactly what it is and the basic idea is
that a Big Mac should cost the same in
all countries when the price is
converted into a common currency
typically the US dollar the index
compares the actual exchange rates with
purchasing power parity providing a
simple and intuitive measure of currency
under or
overvaluation if a Big Mac is more
expensive in one country compared to
another when prices are converted at
current exchange rate the currency in
the first country is considered
overvalued and vice versa so as you can
see in this example using purchasing
power parity rather than noral exchange
rates the Swiss frank is
43.5% overvalued relative to the US
dollar and the Brazilian reel is
15.5% undervalued relative to the US
dollar let's take a quick look at ppp's
advantages and disadvantages in terms of
advantages then it's simple and
intuitive it provides an easy to
understand framework for comparing
different economies secondly it offers a
mechanism to enj for inflation
differences between countries helping
compare economic output and living
standards more accurately and finally
it's useful for long-term economic
planning it benefits strategic planning
investment decisions and long-term
forecasts for businesses and policy
makers in terms of disadvantages then
external factors like tariffs taxes and
trade barriers can skew PPP calculations
leading to inaccuracies secondly the
absence of identical Goods across
markets or significant variations in the
quality of those goods can compromise
the effectiveness of PPP finally it
often struggles to accurately reflect
the value of non-tradeable services such
as Healthcare and education which can
vary wildly between countries in terms
of quality and
cost so what's our take on purchasing
power parity well PPP is essentially an
analytical tool for understanding cost
of living differences across countries
and while it does have its flaws it's
still a powerful model for economic
analysis for business strategists and
policy makers and even Global Investors
it offers insights into where currencies
stand in terms of real economic value
which is invaluable for making informed
decisions companies like efficient soft
that we saw in our example can use PPP
to strategically price their products in
International markets ensuring
competitiveness and affordability whilst
accounting for the real economic
conditions and ultimately maximizing
Revenue so that's it for this lesson
really hope you enjoyed it and I look
forward to speaking to you again soon
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