A familiar sight to international travelers is the golden arches of McDonald's. With restaurants in 120 countries, McDonald's offers the world a fairly standard menu of items at prices listed in many local currencies. Because McDonald's is present in so many countries and has such highly standard menus, in 1986 The Economist began an annual feature comparing prices of the Big Mac sandwich in different countries as a tongue-in-cheek exercise explaining relative currency valuations. In fact, this hamburger price analysis provides an example of the economic principle of Purchasing Power Parity (PPP)—as well as an illustration of why the principle often does not appear to hold as a practical matter.
The accompanying table shows the price of a Big Mac in various countries in April 2003. The first column lists prices in local currencies. Dividing this price by the exchange rate in the second column yields the price in U.S. dollars, which is shown in the third column. These directly comparable U.S. dollar prices show a wide disparity, ranging from $1.40 or less in China, Malaysia, Philippines, Russia and Thailand, to $3.60 or more in Denmark, Sweden and Switzerland. This range seems to violate the principle of PPP, which suggests that the Big Mac should have the same price everywhere.
The underlying foundation of PPP is known as the "law of one price," which states that the price of a particular commodity—say, sesame seeds—should be equal in different countries after accounting for exchange rates between currencies. If sesame seeds were less expensive in one country than in another, a trader could buy sesame seeds in the low-price country and sell them in the higher-price country at a profit. This type of activity, known as arbitrage, would tend to drive the price of sesame seeds higher in the low-price country and lower in the high-price country, until no further profit opportunities existed. This would drive the prices in different countries toward equality. Since the law of one price extends to cover groups of tradable commodities, one would expect the price of "two all-beef patties, special sauce, lettuce, cheese, pickles, onions on a sesame seed bun" to be consistent. On the contrary, as the chart illustrates, the price varies considerably around the world.
Much of the discrepancy between Big Mac prices in different countries is explained by differences in wages and incomes rather than the cost of sesame seeds. A Big Mac—like many other goods—is more than just the sum of its components. The sandwiches are prepared and served by local workers, in restaurants that are also built and maintained by the domestic labor force. Thus the local wage rate is a factor in the total cost of serving a Big Mac. In addition, the local level of earnings affects the demand for McDonald's products. The fourth column of the table in the chart shows average net wages. It is clear from these figures that locations with lower wages tend to have lower Big Mac prices, while those with higher wages tend to have higher Big Mac prices. It is interesting to note, however, that in countries with relatively high prices, the working time required to purchase a Big Mac turns out to be relatively low.
PPP is generally recognized as a long-run property of international price determination, and there is evidence to suggest that price discrepancies between similar countries tend to dissipate over time. Research has found that adjustments to prices that move toward PPP occur through both exchange rate changes and local currency prices. Originally intended as a bite-sized way to learn about the basics of Purchasing Power Parity, the Big Mac index has become a standard in and of itself. It has been cited often in textbooks and has been the subject of serious research on PPP. Who knew a burger survey could provide such a tasteful lesson in international economics?