The Implications Of The PPP Theory

1173 word (5 pages) essay in Economics

24/04/17 Economics Reference this

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The theory is advantageous in the way that its applications make good profit as an observance of absence of PPP. As the above example, suggests that theory of PPP is useful to decide whether it is profitable to invest in a particular country. In Vietnam dollars go substantially further than in the U.S, so venture can be carried out with small funding because labour, supplies and rent will remarkably be cheaper. The theory is frequently used to compare the standard of living between countries, particularly if currency of one country is more valuable, rather than a per-capita nominal Gross domestic product (GDP) comparison at market exchange rates.

One of the most useful benefits of PPP exchange rates lies when governments manipulate the official exchange rates artificially. Sometimes, countries, whose economy is strongly governed by the government, are imposed official exchange rates in order to make their own currency artificially strong. Contrary, the currency’s black market exchange rate is artificially weak. In such cases a PPP exchange rate is likely the most realistic basis for economic comparison.

The results of applying PPP Theory are not as immoderate or agreeable always because there are no downsides of the theory. This theory is applicable only on tradable goods, and not to local services or immobile goods. PPP theory emphasises that when the restrictions to trade are erased, the price of the identical good like BigMac (as a convenient ex) should be the same where it is traded irrespective of different locations. However, (For Example the local price of a BigMac constitutes more than simply the ingredients by which it is composed. Also embedded in the local price is the cost associated with selling and marketing. Even within the same country, the cost of the BigMac can vary depending upon costs to lease or rent the restaurant space and pay for utilities such as power, water, and heat. Rents and utilities are examples of non-tradable goods. While it is possible for titles and deeds to be traded, the location of a property cannot. Thus it may be cheaper to rent a space for a restaurant in Boise, Idaho than in Manhattan, NY, however, it is a useless comparison if one desires to sell BigMacs to the population in Manhattan.) . The Big Mac is based on the good which is very eminent and whose final price which is inclusive of input costs from various segments in the local economy, such as labor, agricultural commodities (ingredients), labor (blue and white collar), advertising, rent and real estate costs, transportation, etc so altogether this describes usefulness of Index of Big Mac. On the other hand, western food in a number of developing economies, characterizes an lavish expensive forte product whose price is by default considered higher the price of traditional product which implies that Big Mac is not a ‘cheap’ conventional product as it is western outcome but an extravagance for the middle classes. Ong (1997) estimates that non traded goods account for 97% of the Big Mac price.

The basis of PPP is Law of one price which suggests the equality of price of identical products in different locations but without taking, transaction costs, transportation costs, tariffs into consideration hence driving the theory away from the real world as all these variables do exist and plays an important role in the real capital competitive market because such variables affects the prices, causing them to differ across comparisons. (Example-When a manufacturer has to transport a good farther to reach a market, the retailer often adds the transportation cost to the final price of the good. The farther away the good has to travel from its original manufacturer, the higher the price for the consumer living in that market. Due to the higher transportation costs, the purchasing power of the dollar for the consumer living in the market further away is less than the purchasing power of the dollar for the consumer living in a closer market. The price for the same good in different markets is not constant and the PPP law of one price does not hold.) These variables have been discussed multiple times in the studies because the research estimates that transportation cost add 7 percent to the price of U.S imports of meat, 6 percent to the import of price of dairy products, 16 percent to the import price of vegetables.

PPP suggest that the purchasing power of consumer will be similar whether purchasing goods in a foreign country or in the home country. The rationale behind this argument is that when inflation is high in the particular country, foreign demands for goods in that country and hence its currency will decrease. In addition, that country�s demand for foreign goods should increase. As a result, the currency of that country will weaken.

In general, currencies in country with higher inflation would weaken according to PPP, causing the purchasing power of goods in the home country vs that of foreign country to br similar.(Paul M. Collier, Samuael Agyei-Ampomah, 2009)

Calculation on PPP exchange-rate is controversial because it is difficult to find analogous basket of goods so as to compare the purchasing power across states. Apart, regular deviations, instability of the market and PPP exchange rates are to be perceived, for instance, as in general (market exchange rate) non-traded goods and services costs are usually lower in the places where incomes are lower. (For Example-A U.S $ exchanged and spent in India will buy more haircuts than a dollar spent in the United States ). The disparity of the relative prices between tradable & non tradable merchandise from high income to low income states or nations is as a result of Balassa-Samueleson effect. In terms of cost, this has delivered a big advantage to workforce rigorous production of tradable merchandises in low income countries (like China), as against high income countries (like Switzerland). The corporate cost advantage is nothing more sophisticated than access to cheaper workers, but because the pay of those workers goes further in low-income countries than high, the relative pay differentials (inter-country) can be sustained for longer than would be the case otherwise. Calculations of PPP are more inclined towards the contribution of primary sector while under emphasize the contribution of industrial and service sector to the nation�s economy. Further, it is quite complicated to estimate purchase power parity because along with the disparity in uniform levels of prices disparity lies between the merchandise also, such as, the difference in food prices may be less than the difference in entertainment prices while greater than the difference in housing prices.

Nevertheless, it is imperative to comprehend that purchasing power parity is a powerful tool which provides us a common approach to assess the economic conditions of diverse nations. We must be acquainted with weakness and limitations of purchasing power parity just like any other device or theory and apprehend to be able to make its best use by controlling limitations within the particular boundary.

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