With increased globalization of markets for goods, services, finance, labor and ideas, the need to measure and compare the standards of living between countries has become important. Production of goods or services and their prices, which showcases the standard of living, is very important for many people like foreign investors, traders, and potential immigrants as it helps them spend their money in a sensible way.
When it comes to comparing the value of money in terms of buying products or goods in two different countries, exchange rate often comes to our mind. Exchange rates are generally used to convert the current values of currency in one country to another. But, exchange rates ignore the domestic economic sectors. Therefore, exchange rate does not reveal the real volume of output of the goods or services that can be bought.
Therefore, to know the differences between the real prices of goods and services across different countries, we need something to measure them on a common scale. This is where Purchasing Power Parity (PPP) comes into picture. Purchasing Power Parity converts local currencies to a common currency and compares the buying power of different currencies.
The purchasing power parity is a method of measuring the effective purchasing power of different countries’ currencies over the same types of goods and services. It also states that, in ideally efficient markets, identical goods should have similar price. While comparing the Purchasing Power Parities of different countries, a standard single currency should be taken in to consideration, such as a US dollar.
But goods and services have widely varying prices across countries when converted to a common currency. You can find more differences in goods or services which are not traded with other countries on international platform such as products that are sold locally, costs of labor, housing, construction, and healthcare services. That is the reason we get more number of haircuts in India compared to US with the same amount of money. This also one of the reasons many foreign companies set up their offices and operate from India. PPP is also the main thing in making the offshoring possible.
PPP is the best method to compare the standards of living in different countries. According to The United Nations Statistics Division (UNSD), the purchasing power parity conversion factor of India compared to US dollar is 16.537 in 2007. Purchasing power parity conversion factor is defined as the required number of units of a country’s currency to buy the same amount of goods and services in their local market as one U.S. dollar would buy in the United States of America. In other words, when a person spends Rs.45 in US to buy a product in his country, you can get the same product in India at Rs.16.50 only. This means products in India are almost three times cheaper than in the US.
The PPP’s law of one price states that all the prices of goods or services should equalize in the absence of local taxes, distributors margin and shipping charges. But the price differences are less for goods that are widely traded in international markets like electronic goods, machinery and equipment. This theory of PPP does not work with countries like India. This is the reason some of the electronic goods and high-end cars are expensive in India than in US.
There are some differences in the prices of goods and services between India and US. Local goods, labor, food, housing, healthcare etc. are cheap in India but some items like electronic goods, and high-end cars are overpriced. Therefore, be aware of things that are expensive and make sensible purchases.