Editing Purchasing power parity (section)

==Issues==

The PPP exchange-rate calculation is controversial because of the difficulties of finding comparable [[Market basket|baskets of goods]] to compare purchasing power across countries.<ref>{{Cite journal|last=Taylor and Taylor|first=Alan and Mark|date=Fall 2004|title=The Purchasing Power Parity Debate|url=http://www.ssc.wisc.edu/~mchinn/taylor&taylor_PPP_JEP.pdf|journal=Journal of Economic Perspectives|volume=18| issue = 4|pages=135–158|doi=10.1257/0895330042632744}}</ref>

Estimation of purchasing power parity is complicated by the fact that countries do not simply differ in a uniform [[price level]]; rather, the difference in [[food prices]] may be greater than the difference in housing prices, while also less than the difference in entertainment prices. People in different countries typically consume different baskets of goods. It is necessary to compare the cost of baskets of goods and services using a [[price index]]. This is a difficult task because purchasing patterns and even the goods available to purchase differ across countries.

Thus, it is necessary to make adjustments for differences in the quality of goods and services. Furthermore, the basket of goods representative of one economy will vary from that of another: Americans eat more bread; Chinese more rice. Hence a PPP calculated using the US consumption as a base will differ from that calculated using China as a base. Additional statistical difficulties arise with multilateral comparisons when (as is usually the case) more than two countries are to be compared.

Various ways of averaging bilateral PPPs can provide a more stable multilateral comparison, but at the cost of distorting bilateral ones. These are all general issues of indexing; as with other [[price index|price indices]] there is no way to reduce complexity to a single number that is equally satisfying for all purposes. Nevertheless, PPPs are typically robust in the face of the many problems that arise in using market exchange rates to make comparisons.

For example, in 2005 the price of a gallon of gasoline in Saudi Arabia was US$0.91, and in Norway the price was US$6.27.<ref>{{cite web|url=https://money.cnn.com/pf/features/lists/global_gasprices/|work=CNN/Money|title=Global gas prices|date=23 March 2005}}</ref> The significant differences in price would not contribute to accuracy in a PPP analysis, despite all of the variables that contribute to the significant differences in price. More comparisons have to be made and used as variables in the overall formulation of the PPP.

When PPP comparisons are to be made over some interval of time, proper account needs to be made of [[inflation]]ary effects.

In addition to methodological issues presented by the selection of a basket of goods, PPP estimates can also vary based on the statistical capacity of participating countries. The [[International Comparison Program]] (ICP), which PPP estimates are based on, require the disaggregation of national accounts into production, expenditure or (in some cases) income, and not all participating countries routinely disaggregate their data into such categories.

Some aspects of PPP comparison are theoretically impossible or unclear. For example, there is no basis for comparison between the Ethiopian labourer who lives on [[teff]] with the Thai labourer who lives on [[rice]], because teff is not commercially available in Thailand and rice is not in Ethiopia, so the price of rice in Ethiopia or teff in Thailand cannot be determined. As a general rule, the more similar the price structure between countries, the more valid the PPP comparison.

PPP levels will also vary based on the formula used to calculate price matrices. Possible formulas include GEKS-Fisher, Geary-Khamis, IDB, and the superlative method. Each has advantages and disadvantages.

Linking regions presents another methodological difficulty. In the 2005 ICP round, regions were compared by using a list of some 1,000 identical items for which a price could be found for 18 countries, selected so that at least two countries would be in each region. While this was superior to earlier "bridging" methods, which do not fully take into account differing quality between goods, it may serve to overstate the PPP basis of poorer countries, because the price indexing on which PPP is based will assign to poorer countries the greater weight of goods consumed in greater shares in richer countries.

There are a number of reasons that different measures do not perfectly reflect [[standard of living]]. In 2011, interviewed by the ''[[Financial Times]]'', a spokesperson for the [[International Monetary Fund|IMF]] declared:<ref>{{Cite web |date=2011-05-29 |title=China's rise, America's demise {{!}} beyondbrics {{!}} News and views on emerging markets from the Financial Times – FT.com |url=http://blogs.ft.com/beyond-brics/2011/04/26/chinas-rise-americas-demise/ |access-date=2023-03-22 |archive-date=2011-05-29 |archive-url=https://web.archive.org/web/20110529174748/http://blogs.ft.com/beyond-brics/2011/04/26/chinas-rise-americas-demise/ |url-status=dead }}</ref>

{{Blockquote|text=The IMF considers that GDP in purchase-power-parity (PPP) terms is not the most appropriate measure for comparing the relative size of countries to the global economy, because PPP price levels are influenced by nontraded services, which are more relevant domestically than globally. The IMF believes that GDP at market rates is a more relevant comparison.|author=[[International Monetary Fund]] spokesperson|source=Webber, Jude (2011). China's rise, America's demise. [[Financial Times]].}}

===Range and quality of goods===
The goods that the currency has the "power" to purchase are a basket of goods of different types:
# Local, non-tradable goods and services (like electric power) that are produced and sold domestically.
# Tradable goods such as non-perishable [[Commodity|commodities]] that can be sold on the international market (like [[diamond]]s).

The more that a product falls into category 1, the further its price will be from the currency [[exchange rate]], moving towards the PPP exchange rate. Conversely, category 2 products tend to trade close to the currency exchange rate. (See also [[Penn effect]]).

More processed and expensive products are likely to be [[tradable]], falling into the second category, and drifting from the PPP exchange rate to the currency exchange rate. Even if the PPP "value" of the Ethiopian currency is three times stronger than the currency exchange rate, it will not buy three times as much of internationally traded goods like steel, cars and microchips, but non-traded goods like housing, services ("haircuts"), and domestically produced crops. The relative price differential between tradables and non-tradables from high-income to low-income countries is a consequence of the [[Balassa–Samuelson effect]] and gives a big cost advantage to labour-intensive production of tradable goods in low income countries (like [[Ethiopia]]), 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 farther in low-income countries than high, the relative pay differentials (inter-country) can be sustained for longer than would be the case otherwise. (This is another way of saying that the wage rate is based on average local productivity and that this is below the per capita productivity that factories selling tradable goods to international markets can achieve.) An equivalent [[cost]] benefit comes from non-traded goods that can be sourced locally (nearer the PPP-exchange rate than the nominal exchange rate in which receipts are paid). These act as a cheaper [[factor of production]] than is available to factories in richer countries. It is difficult by GDP PPP to consider the different quality of goods among the countries.

The Bhagwati–Kravis–Lipsey view provides a somewhat different explanation from the Balassa–Samuelson theory. This view states that price levels for nontradables are lower in poorer countries because of differences in endowment of labor and capital, not because of lower levels of productivity. Poor countries have more labor relative to capital, so marginal productivity of labor is greater in rich countries than in poor countries. Nontradables tend to be labor-intensive; therefore, because labor is less expensive in poor countries and is used mostly for nontradables, nontradables are cheaper in poor countries. Wages are high in rich countries, so nontradables are relatively more expensive.<ref name="Krugman"/>

PPP calculations tend to overemphasise the primary sectoral contribution, and underemphasise the industrial and service sectoral contributions to the economy of a nation.

===Trade barriers and nontradables===
The law of one price is weakened by transport costs and governmental trade restrictions, which make it expensive to move goods between markets located in different countries. Transport costs sever the link between exchange rates and the prices of goods implied by the law of one price. As transport costs increase, the larger the range of exchange rate fluctuations. The same is true for official trade restrictions because the customs fees affect importers' profits in the same way as shipping fees. According to Krugman and Obstfeld, "Either type of trade impediment weakens the basis of PPP by allowing the purchasing power of a given currency to differ more widely from country to country."<ref name=Krugman>{{cite book|last=Krugman and Obstfeld|title=International Economics|year=2009|publisher=Pearson Education, Inc.|pages=394–395}}</ref>  They cite the example that a dollar in London should purchase the same goods as a dollar in Chicago, which is certainly not the case.

Nontradables are primarily services and the output of the construction industry. Nontradables also lead to deviations in PPP because the prices of nontradables are not linked internationally. The prices are determined by domestic supply and demand, and shifts in those curves lead to changes in the market basket of some goods relative to the foreign price of the same basket. If the prices of nontradables rise, the purchasing power of any given currency will fall in that country.<ref name="Krugman"/>

===Departures from free competition===
Linkages between national price levels are also weakened when trade barriers and imperfectly competitive market structures occur together. Pricing to market occurs when a firm sells the same product for different prices in different markets. This is a reflection of inter-country differences in conditions on both the demand side (''e.g.'', virtually no demand for pork in Islamic states) and the supply side (''e.g.'', whether the existing market for a prospective entrant's product features few suppliers or instead is already near-saturated). According to Krugman and Obstfeld, this occurrence of [[product differentiation]] and segmented markets results in violations of the law of one price and absolute PPP. Over time, shifts in market structure and demand will occur, which may invalidate relative PPP.<ref name="Krugman"/>

===Differences in price level measurement===
Measurement of price levels differ from country to country. Inflation data from different countries are based on different commodity baskets; therefore, exchange rate changes do not offset official measures of inflation differences. Because it makes predictions about price changes rather than price levels, relative PPP is still a useful concept. However, change in the relative prices of basket components can cause relative PPP to fail tests that are based on official price indexes.<ref name="Krugman"/>

===Global poverty line===
The global poverty line is a worldwide count of people who live below an international [[poverty line]], referred to as the dollar-a-day line. This line represents an average of the national poverty lines of the [[least developed country|world's poorest countries]], expressed in international dollars.  These national poverty lines are converted to international currency and the global line is converted back to local currency using the PPP exchange rates from the ICP. PPP exchange rates include data from the sales of high end non-poverty related items which skews the value of food items and necessary goods which is 70 percent of poor peoples' consumption.<ref>{{Cite web|url=https://www.carnegiecouncil.org/publications/archive/policy_innovations/index|title=Policy Innovations Digital Magazine (2006–2016) |website=Carnegie Council for Ethics in International Affairs |language=en-US|access-date=2019-09-27}}</ref> Angus Deaton argues that PPP indices need to be reweighted for use in poverty measurement; they need to be redefined to reflect local poverty measures, not global measures, weighing local food items and excluding luxury items that are not prevalent or are not of equal value in all localities.<ref>[http://www.princeton.edu/~deaton/downloads/presidential%20address%2019january%202010%20all.pdf Price indexes, inequality, and the measurement of world poverty Angus Deaton, Princeton University]</ref>