Big Mac Index Essay ⋆ Business Essay Examples ⋆ EssayEmpire

The Big Mac Index compares the prices of McDonald’s Big Mac burgers, a fast food item produced and sold in 120 countries worldwide, as an indicator of possible overvaluation or undervaluation of the local currency relative to the U.S. dollar. The tongue-in cheek analyses give an easily digestible example of the economic theory on purchasing power parity (PPP) and its applicability in the practical sense.

The Big Mac Index is based on the PPP theory, which holds that the price of a certain commodity should be the same in different countries and, if they are not so, that the exchange rate between the currencies of two countries will gradually adjust toward parity, or equality. This notion also extends toward an identical basket of goods and services. If the prices of all components of this basket are the same, then the PPP theory implies that the price for the basket should also be the same among countries.

If the price is not the same, the price difference (called arbitrage) between countries will encourage traders to buy the commodity in the lower-priced country and sell it for a profit in the other country with higher prices. The trade creates demand and induces commodity prices to rise in the lower-priced country; it also increases supply and influences prices to go down in the high-priced country, until the point is reached when no more price difference exists and there is no more profit to be made.

The Big Mac Index uses the Big Mac burger as the reference commodity, or basket, consisting of its beef patties, cheese, lettuce, spices, and secret sauce on a bun studded with sesame seeds. The index takes the prices of the Big Mac burger in all 120 countries where it is available. The Big Mac PPP refers to the exchange rate that would make the prices of hamburgers in any of the 120 countries identical to prices in the United States (dollars). A currency would be considered undervalued or overvalued when its actual market exchange rate is compared with the Big Mac PPP.

For example, in the last annual publication (every July) of the index in 2007, the burger price in the United States was $3.41 (the average of prices in four cities: New York, Chicago, Atlanta, and San Francisco). In comparison, the same burger in the United Kingdom (UK) cost £1.99, which was equivalent to $4.00 at the prevailing market exchange rate of $2.01/£1. However, the implied Big Mac PPP is only $1.71 (actual U.S. price in dollars divided into actual UK price in pounds, i.e., $3.41/£1.99). Comparing the Big Mac PPP of $1.71 and the official exchange rate of $2.01, the UK pound has a 17.5 percent advantage and is thus overvalued against the dollar. It can be expected to depreciate in order to reach the PPP rate of £1=$1.71 from the existing £1=$2.01. Put another way, the burger is 17.5 percent more expensive in the UK than in the United States at the existing exchange rate, and is said to be 17.5 percent overvalued versus the dollar.

On the other hand, the same burger in China costs 11.0 yuan, which converts to $1.45 at the prevailing market exchange rate of $1= 7.60 yuan. The implied PPP is 11 yuan/$3.41 or 3.23 yuan per dollar. But the market exchange rate is 7.60 yuan per dollar, and the yuan is therefore undervalued by about 57.5 percent. The yuan can thus be expected to appreciate.

Use Of The Big Mac Index

The Big Mac Index was developed by The Economist magazine in the UK in 1986. It was not designed to be a precision tool for economic forecasting but simply as a lighthearted test of the PPP. Even The Economist acknowledges there are wide divergences in prices across the McDonald’s world. Unlike regular commodities, there is no cross-border trade in burgers (as required by PPP). The index, however, has been used as a measure of the costs of living in different countries. Average prices tend to be lower in less developed countries, making their currencies seem cheaper in comparison to more developed countries.

Goods that are traded across countries will probably be similarly priced, whether in developed or less developed countries. But products that by their nature are traded only in the domestic market, e.g., labor-intensive services and rents, are usually priced lower in poorer countries. London will have more expensive barbers than Beijing, for example. Price disparities also arise from differences in transportation costs, taxation systems, barriers to trade, and other factors. The level of local wages is also a significant influence on the cost of serving the burgers.

An important implication of the PPP is that the real size of a poor country’s economy and the associated standards of living will tend to be understated if the economic figures are converted into dollars using the prevailing exchange rates. The PPP, however, tends to yield higher economic figures for an economy than market exchange rates. China’s economy, for instance, will appear more than twice as much when converted at Big Mac PPP than at market exchange rates. The International Monetary Fund also uses more sophisticated models of PPP.

Economic rankings change dramatically when the PPP is used for converting and comparing economic performance. Emerging economies turn out to be greater contributors to global economic output than market exchange rates would indicate. Conversion of economic output using PPP shows that emerging economies contributed nearly half of world output in 2004. But conversion using market exchange rates shows these countries contributing less than one-quarter.

Economists generally acknowledge PPP as descriptive of how international prices are determined in the long run. Over time, similar countries do tend to have smaller price differentials. There is also general recognition that it provides a better idea of relative economic rankings than market exchange rates.

Although it was originally meant to provide a simple, lighthearted means to illustrate the fundamentals of purchasing power parity, the Big Mac index has become an essential feature of the consumer’s menu for understanding more complex concepts of currency valuations and exchange rates.

Bibliography:

Gavyn Davies, “Gavyn Davies Does the Maths: The Big Mac Index Says Sterling Should Fall,” The Guardian (June 8, 2006), www.guardian.co.uk (cited March 2009);
Economist Staff, “Food for Thought: The Big Mac Index,” The Economist (May 28, 2004), www.cfo. com (cited March 2009);
Campbell R. McConnell, Microeconomics: Principles, Problems, and Policies (McGrawHill Professional, 2005);
Michael R. Pakko and Patricia S. Polland, “Burger Survey Provides Taste of International Economics,” Federal Reserve Bank of St. Louis–Regional Economist (January 2004);
“The Big Mac Index: Sizzling,” The Economist (July 5, 2007), www.economist.co.uk (cited March 2009).

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