Purchasing Power Parity Explained

Summary

This 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

00:00

💸 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.

05:01

🌐 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.

10:02

🍔 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.

Keywords

💡Purchasing Power Parity (PPP)

Purchasing Power Parity (PPP) is an economic theory that suggests exchange rates between currencies should adjust so that identical goods or services cost the same in different countries when measured by a common currency. In the video, it is used to explain why products like a Big Mac or Coca-Cola vary in price across countries. PPP helps businesses set prices that are competitive and affordable in different markets by accounting for local purchasing power.

💡Nominal Exchange Rate

The nominal exchange rate is the rate at which one country's currency can be exchanged for another country's currency in the market. In the video, it's described as the price at which $1 can buy 0.6 pounds. It reflects the current exchange rate without considering factors like inflation or purchasing power differences, which is why it can fluctuate due to market forces like speculation and interest rates.

💡Real Exchange Rate

The real exchange rate adjusts the nominal exchange rate to reflect the true purchasing power of a currency in relation to another. In the video, the real exchange rate is presented as a more accurate reflection of what goods cost in different countries, compared to the nominal rate. For example, a $1,000 basket of goods in the US might cost more than £600 in the UK, revealing that the real exchange rate is different from the nominal rate.

💡Undervalued Currency

A currency is considered undervalued when it buys less than what is expected in another country, meaning it has less purchasing power. The video uses an example where the US dollar is undervalued against the British pound, as a person would need $1,333 to buy a basket of goods worth £800. This concept helps businesses understand when their currency might not go as far in foreign markets, affecting pricing strategies.

💡Overvalued Currency

An overvalued currency has more purchasing power than expected when compared to another currency. In the video, the British pound is described as overvalued in comparison to the US dollar because it holds more purchasing power in the US. This impacts how businesses price goods internationally, as an overvalued currency might make products seem more expensive in foreign markets.

💡Big Mac Index

The Big Mac Index is an informal measure of PPP created by The Economist, which compares the price of a Big Mac in different countries to assess currency valuation. In the video, it is explained as a way to gauge whether currencies are overvalued or undervalued by comparing Big Mac prices across countries in US dollars. The Swiss franc, for example, is shown as overvalued, while the Brazilian real is undervalued.

💡Inflation

Inflation is the rate at which the general level of prices for goods and services rises, eroding purchasing power. In the context of the video, inflation differences between countries can cause discrepancies in the nominal exchange rate, making it necessary to use real exchange rates and PPP to compare prices accurately. Inflation impacts how businesses should adjust their prices in foreign markets to remain competitive.

💡Revenue Maximization

Revenue maximization refers to strategies businesses use to increase their total income. In the video, it's shown how Efficient Soft uses PPP to adjust prices in China and India, leading to a significant increase in customers and overall revenue. By setting prices according to local purchasing power, companies can boost sales in international markets without sacrificing profits.

💡Tariffs

Tariffs are taxes imposed on imported goods and can distort PPP calculations by artificially inflating the prices of foreign products. The video notes that one disadvantage of using PPP is that external factors like tariffs can skew the true cost of goods between countries, making it harder to accurately assess purchasing power and set fair prices.

💡Strategic Pricing

Strategic pricing is the practice of setting prices based on an analysis of market conditions, purchasing power, and competitiveness. In the video, Efficient Soft uses strategic pricing by adjusting its subscription costs in China and India to reflect local economic realities, which allows the company to increase its customer base and revenue. This approach ensures products remain affordable while maximizing sales potential.

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