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On my recent holidays, I visited Peru, enjoying the delicious cuisine and tourist attractions such as Machu Picchu in Cusco, Colca’s Canyon in Arequipa, and cheaper services relative to Australia, such as haircuts, dental appointments, eye tests, taxi rides, among others. For instance, a premium haircut in a wealthy neighbourhood in Lima that includes a cold beer, washed hair and product on your hair was 60 Peruvian soles (equivalent to US$16.10 ). Conversely, in Brisbane, a similar premium service is about $70 (equivalent to US$46.10) (1).    

The same service is approximately 2.9 times more expensive at market exchange rates in Brisbane than in Lima. But what determines this price disparity? What does it mean in terms of overall well-being?  Luckily, renowned economists have offered explanations for different price levels across economies that will be discussed in the following paragraphs.  

The Balassa-Samuelson hypothesis

The economic rationale for prices in poorer countries being lower than those in richer countries is based on the Balassa-Samuelson hypothesis, named after its independent discoverers, the Hungarian economist Bela Balassa and the Nobel-Prize-winning US economist Paul Samuelson. This hypothesis is based on the observation that wealthier countries are more productive in the tradable sector (e.g. Australian agricultural goods such as wine and barley compared with Peruvian similar goods) than less wealthy countries. This will increase the relative price (and wages) in the non-tradable sector (e.g. Australian barbershops), resulting in higher prices in the richer economy than in the poorer economy. This is because the more efficient tradable sector competes with the non-tradable sector for labour, pushing up wages. 

The Balassa-Samuelson hypothesis is considered an empirical regularity, also known as the Penn-Balassa-Samuelson effect. This consists of the positive correlation between price levels and income per capita across countries (see Figure 1 for barbershop costs and GDP per capita). This effect applies across a broad range of countries. The empirical fact does not hold among low-income countries specifically because they possess a greater heterogeneity in terms of structural factors (e.g. infrastructure, transport costs, etc.), as noted by a senior economist at the Bank of Italy, Fadi Hassan (2).  

Figure 1. GDP per capita and men’s average barbershop prices in 2022

Source: IMF for GDP per capita and NetCredit for the average barbershop prices.

While most non-tradable products and services are cheaper in low-income economies, others may be more expensive. For example, in Lima, Peru, an important gastronomic destination where four restaurants are included in the World’s 50 best restaurants, some restaurants charge more for gourmet sampling menus than restaurants offering a similar service in Brisbane. Therefore, other granular factors such as wages, rents, and supply and demand characteristics, among other things, are needed to explain price disparities between both cities comprehensively. 

Market exchange rates versus Purchasing Power Parity exchange rates

Because of the lower relative prices of non-traded goods and services in emerging economies compared with advanced economies (e.g. Australia versus Peru or China), using market exchange rates, we would get an inaccurate idea of the purchasing power of the emerging economy. This is because a market exchange rate does not reflect the lower cost of non-traded goods and services (e.g. haircuts) in emerging economies. Hence, the well-being of emerging economies is underestimated. A more accurate picture emerges if we use what are known as Purchasing Power Parity (PPP) exchange rates instead.

The PPP rate is a theoretical exchange rate that takes into account the cost of a similar basket of goods and services between two countries. For example, following the definition of Grewal and Sheehan (2005), the PPP rate for the Peruvian soles against the Australian dollar is defined as the number of soles needed to buy, in Peru, the same amount of goods and services as 1 Australian dollar would buy in Australia. The idea is to reflect the greater purchasing power of the local currency domestically because it can purchase less expensive nontraded goods than internationally. This boosts the GDP per capita of emerging economies to reflect the greater purchasing power of its currency domestically due to cheaper nontraded goods. As a result, in 2022, in market exchange rate terms, China’s GDP per capita was US$12,744 compared with US$21,484 in PPP terms (3).

An important empirical tool to observe how PPP works is the Big Mac index created by The Economist in 1986, which is based on the theory of PPP. The Big Mac cost is used as an informal proxy of the basket of goods and services that goes into the PPP calculation. To illustrate, one Big Mac costs 14.90 Soles in Peru and $7.45 in Australia, implying the PPP exchange rate of $1 to 2 Soles. However, the market exchange rate is $1 to 2.44 Soles. This would suggest that the Peruvian Soles is 18% undervalued against the Australian dollar, based on the Big Mac index.

The IMF’s Tim Callen has observed that GDP per capita measures based on PPP exchange rates are superior to those based on market exchange rates:

…Any analysis that fails to take into account these differences in the prices of nontrade goods across countries will underestimate the purchasing power of consumers in emerging market and developing countries and, consequently, their overall welfare. For this reason, PPP is generally regarded as a better measure of overall well-being.

Figure 2. GDP per capita comparisons between Australia and Peru: market exchange rate and PPP methods

Source: IMF (April 2023).

Notes: The GDP per capita PPP considers 2017 as the base year in international $. Estimated values for Australia are after 2021, and for Peru, they are after 2017.

Figure 2 shows how Australia’s GDP per capita at market exchange rates fell over the late 1990s as the Australian dollar depreciated and rebounded strongly from around 2002-03 as the Australian dollar appreciated as Chinese demand for our mineral exports surged. While the average value of the Australian dollar in 1999 was 0.6440 US dollars, by 2004, it averaged 0.7364 US dollars. This meant that, in US dollar terms, Australia’s GDP per capita increased 51.0% between 1999 and 2004, but in PPP terms, it only increased by 11.6%. 

The use of market exchange rates or PPP rates affects the global ranking of economies. For instance, Figure 3 shows that China has overtaken the US on some GDP measures using PPP rates but is still smaller than the US in GDP measured at market exchange rates.

Figure 3. GDP comparisons between USA and China: market exchange rates and PPP methods

Source: IMF (April 2023).

Notes: The GDP per capita PPP considers 2017 as the base year in international $. Estimated values for the USA and China are after 2022.

In summary, empirical evidence and economic theory suggest that prices in developed economies are higher than in less developed economies, which is mainly explained by the differences in productivity in the tradable sectors. This price disparity can bring inaccuracies in well-being comparisons. These inaccuracies can be ameliorated using the PPP exchange rate method, especially when developing economies, which have lower prices in their non-traded sectors,  are included in the analysis. When comparing living standards internationally, figures based on PPP exchange rates should be used.

Published on 25 January 2024. This article was prepared by Adept Research Economist Arturo Espinoza with input from Director Gene Tunny. For further information please get in touch with us via contact@adepteconomics.com.au or by calling us on 07 3085 7417.