Purchasing Power Parity

Definition, Calculation, and How It's Used

PPP makes a Big Mac cost the same in China and the United States.. Photo: China Photos/Getty Images

Definition: Purchasing power parity (PPP) is an economic theory that states residents of one country should be able to buy the goods and services at the same price as residents of any other country over time.

Why do economists say that? Because competition in international trade allows people to shop around for the best price. Given enough time, everyone's purchasing power will become equal, or reach parity.

PPP is based on the law of one price. That states that once the difference in exchange rates is accounted for, then everything would cost the same. (Source: Journal of Economic Literature, Kenneth Rogoff, Purchasing Power Parity Puzzle, June 1996)

That's not true in the real world on a day-to-day basis. Everything can't be traded easily, thanks to transportation costs, taxes and tariffs. Some things, such as real estate and services (like haircuts), can't be shipped. Not everyone throughout the world has the same access to international trade. For example, someone in rural China can't choose between every good and service throughout the world. Perhaps one day Amazon.com and other online retailers will enable actual purchasing power parity.

PPP Calculation

Purchasing power parity is also a calculation that determines how much things would cost if parity did exist. It takes into account the impact of exchange rates.

It's calculated by determining what each item purchased in a country would cost if it were sold in the United States. These are then added up for all the final goods and services produced in that country for that given year.

Parity is tedious to compute. A U.S. dollar value must be assigned to everything.

That includes items not widely available in America. For example, there aren't too many ox-carts in the United States. Would its U.S. price accurately describe its value in rural Vietnam, where it's needed to grow rice?What is the U.S. price equivalent of a haircut in a country where family members give it?

For many developing countries, the PPP is estimated using just a multiple of the official exchange rate (OER) measure. For developed countries, the OER and PPP measures of GDP are more similar, since their standards of living are closer to the United States.

How It's Used

Purchasing power parity is used in many situations. The most common is to adjust for the price differences between countries. For example, China produced $10.36 trillion in goods and services in 2014. The U.S. produced $17.46 trillion. However, you cannot compare the two without taking into account the fact that the cost of living in China is much lower than in the United States.

For example, a McDonald's Big Mac costs $4.79.

In China, you can get the same thing for only $2.77. People in China don't need as much income because it costs less to live. (For more fun comparisons, see The Economist's Big Mac Index)

That's because China artificially sets the value of its currency to be lower than the U.S. dollar. It intentionally wants its cost of living to be lower, so it can pay its workers less. As a result, its exports cost less, making it more competitive on the global market. For more, see Currency Wars.

Purchasing power parity solves the problem of comparing countries with different standards of living. It recalculates the value of a country's goods and services as if they were being sold at U.S. prices. Under PPP, a Chinese Big Mac costs $4.79, the same as it does in the United States. As a result, China's GDP under PPP is $17.63 trillion, which makes it the world's largest economy, ahead of the EU and the United States. That's why the CIA provides GDP estimates on both an official exchange rate and a purchasing power parity basis.

Without purchasing power parity, China's GDP per capita would only be around $6,475, lower than the standard of living in Ukraine, Algeria or Kosovo. With PPP, each of the 1.3 trillion people receives (on average) the benefit of $12,900 in economic production. That's better, but still only on the level of Jamaica and worse than Cuba. It's far less than the U.S. GDP per capita of $52,800. That's because the United States divides its GDP among only 319 million people. (Source: CIA Factbook)

Although this doesn't happen very often, PPP is also used to set the exchange rate for new countries. It is used to forecast future real exchange rates. Article updated January 22, 2016.

Continue Reading...