Of eggs, meat, and Purchasing Power Parity in economics
Regional, Economic Talk, 7/30/1998

Editor's note: Our reader Michael H. asked: In the "Economy" section of the "Basic Country Facts" (on our site) you use the term "GDP - Purchasing Power Parity". Could you please explain this definition, what the parity is in comparison to and how PPP is calculated? We would like to use this opportunity to increase our focus on basic economic understanding in future editions.

We hope that examples will help you understand the difference between a Gross Domestic Product (GDP) computed the "standard" way based on trade exchange, value of international currency (dollar), and the so-called Purchasing Power Parity value. Please keep in mind that the numbers we are using here are hypothetical, but are used to simplify and illustrate our points.

If a pound of meat in the US costs $5 and in Japan costs $20 (equivalent in yen), and if the Per Capita Income of a US citizen is $20,000 and that of a Japanese citizen is $20,000 (equivalent in yen), then it is clear that the US citizen can buy more meat for the same amount of money. So if were to count how much of a"product" money buys, in the US, we find the same amount of money buys more products than in Japan in this example.

This gives a US citizen a higher standard of living (all other things being the equal). This is at the heart of how GDP is computed using "Purchasing Power Parity" or PPP.

The implication is that although a Japanese citizen may have the same per-capita income as the US, and therefore, the GDP of both countries will be the same if we assume both countries have the same population, then it becomes clear that although the Japanese GDP when computed in dollars amounts to 4 trillion dollars, in "Purchasing Power Parity" computation that number becomes 3 trillion dollars! That is, the Japanese as a whole, can buy less "products" than US citizens as a whole.

So although both GDPs would be computed at $4 trillion each, the US GDP would be bigger than that of Japan when computed using "Purchasing Power Parity." So if you are a US citizen, that means, although you make the same amount of money as a Japanese citizen, you are likely experiencing a higher standard of living then your counterpart in Japan who makes the same amount of money.

Now for poor countries, the opposite happens. That is, since a Chinese citizen can rent a house for $10 dollars per month, as opposed to a US citizen paying $500 per month, you can see (all other things being equal) that the Chinese has a higher standard of living than what his income would lead an American to believe, despite the fact that a Chinese may earn 50 dollars per month. That is, the Chinese in China can buy more products for the same amount of money that a US citizen can in the US. In fact, a lot more in some cases, as this example demonstrates.

The result is that although Chinese economy rated a GDP of (1 trillion dollars, lets say), the "Purchasing Power" of the economy as expressed by the "Purchasing Power Parity" computation may result in a 5 trillion dollar economy when compared to the US economy. This is a 5 times increase in the size of the Chinese economy by simply changing how it is computed from straight dollar count to how much those dollars buy!

This is the basic idea behind "Purchasing Power Parity" computation of the GDP of an economy. It is worth adding that (as you probably have guessed by now) the "resulting difference" between the two ways of computing the GDP is dependent on how much open trade there is in a country, and depending on how well the country is integrated in the world economy and its products' competitiveness, as these things tend to equalize how much the same money can buy. That is why you will find less difference in western countries' GDPs when computed the standard way, or the "Purchasing Power Parity" way.

Example: In a closed economy with no egg production you can control the price of eggs, but in an open economy, the price of eggs will be determined by the international market value, since if the price is too high, people will import cheaper eggs, and if it is too low, people will export eggs for profit, so that the price of eggs comes into equilibrium with the international price. Now this assumes perfect market conditions, which never exist, and does not account for transport cost of the product (eggs).

In addition, if a house in China costs $10 per month and no one wants to live there because there is no demand for housing, for whatever reason, then that does not mean that the price of housing will go up (to reach equilibrium with the international market) since you cannot export that house.

Other issues to think about include how exchange rates effect GDP calculations.

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