The Concept of Purchasing Power Parity

With the increased globalization of markets for goods, services, finance, labor and ideas, the need to measure and compare the standards of living between the countries has become very important. Production of goods or services and their prices, which showcases the standard of living are very important for many people like foreign investors, traders, and potential immigrants as it helps them to spend their money in a sensible way.

When it comes to comparing the value of money in terms of buying products or goods in two different countries, exchange rate often comes to our mind. Exchange rates are generally used to the convert the current values of currency in one country to another. Exchange rates ignore the domestic economic sectors where prices are fixed without any consultation with other countries. Therefore, exchange rate does not reveal the real volume of output of the goods or services that can be bought.

Therefore to measure the differences between the real prices of goods and services across different coun¬tries, we need something to measure them on a common scale. This is where Purchasing Power Parity (PPP) comes into picture. Purchasing Power Parity converts local currencies to a common currency and compares the buying power of different currencies. The purchasing power parity is a method of measuring the effective purchasing power of different countries’ currencies over the same types of goods and services. It also states that, in ideally efficient markets, identical goods should have similar price. While comparing the Purchasing Power Parities of different countries, a standard single currency should be taken such as a US dollar.

But goods and services have widely varying prices across countries when converted to a common currency. You can find more differences in goods or services, which are not traded with other countries on international platform such as products that are sold locally, costs of labour, housing, construction, and healthcare services. That is the reason we get more number of haircuts in India compared to US with the same amount of money. This also one of the reasons many foreign companies to set up their offices and operate from India. PPP is the main thing that is making the offshoring possible.

PPP is the best method to compare the standards of living in different countries. According to The United Nations Statistics Division (UNSD), the purchasing power parity conversion factor of India compared to US dollar is 16.537 in 2007. Purchasing power parity conversion factor is defined as the required number of units of a country’s currency to buy the same amount of goods and services in their local market as one U.S. dollar would buy in the United States of America. In other words, when a person spends Rs.45 in US to buy a product in his country, you can get the same product in India at Rs.16.50 only. This means products in India are almost three times cheaper than in the US.

According to 2005 International Comparison Program by World Bank, individual household con¬sumption expenditure was $1,183 in India where as the same thing in US was about $29,368. Expenditure on household food consumption was $317 in India, for the same purpose they spent $1,998 in US. Household expenditure on health was $485 in India and it was $5,853 in US.

The PPP’s law of one price states that all the prices of goods or services should equalize in the absence of local taxes, distributors margin and shipping charges. But the price differences are less for goods that are widely traded in international markets like electronic goods, machinery and equipment. The theory of PPP is not working here with countries like India. This is the reason some of the electronic goods and high-end cars in India are expensive than in US.

There are some differences in the prices of goods and services between India and US. Local goods, labour, food, housing, healthcare etc. are cheap in India but some items like electronic goods, and high-end cars are overpriced. Therefore be aware of things that are expensive and make sensible purchases.

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