August 26, 2015    3 minute read

The Peculiar Big Mac Index

   August 26, 2015    3 minute read

The Peculiar Big Mac Index

In almost every country, the Big Mac is made with the same ingredients, and in 1986, The Economist invented the Big Mac index to see whether currencies were over or under valued. The index is based on the notion of PPP, (purchasing-power parity) which says that exchange rates, in the long run, will converge to a rate that will mean that identical goods expressed in different currencies will have the same price when converted to the same currency. In July of 2015, if you were to buy a Big Mac in America, the average price you would pay was $4.79, whereas in China for the same period, a Big Mac was cheaper at $2.74 which suggests that the Yuan undervalued at that period in time by 43%.

Purchasing Power Parity

PPP states that the price of a good in one country is the same as the price of that identical good in another country after being adjusted for the exchange rate. So if the price of a Big Mac in the U.S. is high compared to a Big Mac in China, people in China would prefer to buy a Big Mac domestically, the lack of interest in an American Big Mac would, in theory, lead to a decrease in their price until they are equal to China.

However, in the short term, there is evidence to suggest that for many goods PPP is not observed, with Pakko & Pollard mentioning numerous reasons why PPP does not apply in reality. One reason is the inclusion of transport costs from the importation of these goods, leading to an increase in the price of the good which may lead to that good being more expensive than if it was bought domestically. The differences in taxes between the importing and exporting countries, for example VAT would lead to price distortions between the two countries with the good being more expensive in the country with the higher taxes.

Import tariffs may be implemented in a country, with the aim of limiting supply causing excess demand and an inevitable rise in price of the imported good. There are also costs involved in the production and sale of the good that are non-tradable, such as the cost of premises and labour which would vary from country to country, in countries where non-traded service costs are large, a Big Mac is likely to be more expensive, which may lead to that county’s currency to be over-valued in relation to a country with low non-traded service costs. Prices between countries can also be determined by the market make up in each country, if McDonalds is a monopoly in a specific country, they may take advantage of their market power and increase the price of a Big Mac leading to greater profits. Overall, PPP does not tend to hold in the real world over the short term, however there is evidence to suggest that in the long run relative PPP has held.

One can find the cheapest Big Mac in Venezuela at a measly 67 cents whereas the most expensive Big Mac can be found in Switzerland at a whopping $6.82. Funnily enough, the Big Mac is one of the only goods that is produced with, more or less, the same ingredients worldwide meaning the Big Mac index can tell us a lot about currencies and is a fun way to see whether they are correctly valued.

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