Why News of China’s Economy Surpassing the U.S.’s Should Be Met with Caution

The World Bank’s new measure of gross domestic product based on the notion of purchasing power parity (PPP) suggests that China will surpass the United States to become the world’s largest economy by the end of 2014, at least a decade sooner than the most optimistic predictions made before.

In U.S. dollars, this new measure of GDP put China’s economy at almost $13.5 trillion in 2011, equivalent to 87 percent of the U.S. economy ($15.5 trillion).¹ When factoring in the two countries’ respective annual growth rates, the U.S. will cease to be the largest economy this year, ending the supremacy status it has held since the 1870s. However, PPP-based measures of GDP can be highly misleading and should be approached with great caution.

PPP measures the purchasing power of money on the quantity of the “same” goods, but fails to capture the quality differences of these goods, which can vary dramatically across countries. Since the quality of the “same” goods is significantly lower in poor countries than in rich countries, the PPP-based measure of GDP tends to overestimate the national income of developing countries and underestimate that of developed ones, making the income differences between poor and rich countries appear much smaller.

Regarding the U.S. and China, the quality of most durable and nondurable consumption goods and services tends to be significantly higher in the U.S. Consider an average 1,000-square-foot 100-square-foot apartment in China. Its quality, including the utilities and surrounding environment, is at best comparable to that of a 1960s apartment in the U.S. Moreover, the average square foot of living space in China is associated with an apartment, while such space in the U.S. is associated with a single-family house with a yard. Also, $50 can buy a pair of good quality “Made in China” shoes in the U.S., but a pair of shoes with comparable quality can cost two or even five times more in China, based on the current exchange rate of 6 yuan per dollar.²

There are many reasons why the prices of the same goods can vary so much across poor and rich countries. One is trade restrictions and tariffs. Developing countries tend to impose higher tariffs on imported goods to protect infant industries.

Another is market segregation. According to standard international trade theory, high-productivity firms opt to export their goods, while low-productivity firms opt to serve only the domestic market due to high export costs (such as shipping and additional marketing costs). The marginal cost of better quality increases more rapidly for firms with low productivity or inferior technology, and consumers in poor countries have much lower income than their foreign counterparts. Hence, firms of developing countries with low productivity opt to produce low-quality goods and stay only in the domestic markets.³

Therefore, the purchasing power of international currency (such as the dollar) in developing countries tends to be high on low-quality goods but low on high-quality goods. This is why foreign travelers from rich countries often find that the same luxury goods available at home are far more expensive in developing countries, but the opposite is true for low-quality goods, especially for goods with more nontradable elements (land and labor).⁴

Since the majority of people in poor countries consume low-quality goods, PPP-based measures tend to overestimate poor countries’ GDP relative to rich countries. For this reason, the World Bank’s new measure of China’s GDP in 2011 is overestimated compared to that based on the nominal exchange rate, which indicates that Chinese GDP in 2011 was about $7.3 trillion, or 47 percent of U.S. GDP.

¹ “Purchasing Power Parities and Real Expenditures of World Economies: Summary of Results and Findings of the 2011 International Comparison Program,” The World Bank, 2014.

² Consider that one pair of Nike shoes costs about $76.49 in the U.S., while the same costs $108.36 in China. This gap tends to be larger for leather shoes.

³ Why don’t the high-productivity firms simultaneously serve the foreign market with high-quality goods and the domestic market with low-quality goods then? Low-quality goods have much lower markups, but not necessarily lower domestic market-transaction costs; so, with entry costs and limited productive capacity it is better for high-productivity firms to export, or to target only the upper-income group of domestic customers.

⁴ In the same city in China, a low-quality, standard single hotel room can cost as low as a few yuan per night, while a high-quality one can cost as much as a few thousand yuan per night. This price gap reflects quality differences and is related to the income gap, which is much smaller in the U.S.

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