Burgernomics: Where's The Beef?

I was going to give this article a pass, but I had a little epiphany over the weekend that makes it worthwhile commenting on - not so much the article itself, but rather the example Tan Sri Lin See Yan makes of The Economist's Big Mac Index (here and here for the latest readings).

The Big Mac Index was based on a simple idea: since the Big Mac is relatively homogeneous (same ingredients, and almost the same in terms of other inputs), differences in pricing across countries should illustrate differences in purchasing power, and thus gives a clue as to the relative strength or weakness of exchange rates.

For example, the average USD price of the Big Mac is $3.57 while the average EUR price is €3.31 as at July 13th, which gives an implied USDEUR exchange rate of USD1.08. Comparing this to the actual USDEUR exchange rate of USD1.39, according to this measure the EUR is 29% overvalued against the USD.

If we take Malaysia as an example instead, with a local price of RM6.77 we get an implied-PPP exchange rate of RM1.896 compared to the actual of RM3.60, giving an undervaluation of 47%. If you look at most East Asian countries, you'll find a greater or lesser degree of undervaluation.

This type of analysis has therefore tended to confirm the stylised notion that East Asian economies are currency manipulators, and have kept their currencies cheap in relation to the USD to boost their export-growth models. I won't delve into more formal proofs (and dis-proofs) of this notion, but rather go into the potential hazards of relying on the Big Mac index as a PPP measure.

The standard critique is that Big Macs incorporate local inputs, which are generally composed of non-tradables (land, labour, localised taxes etc). I'd also add the potential for price differentiation from local supplies of tradables, particularly the ingredients themselves - beef, bread, vegetables etc, although the sauce as I understand it is a McDonalds monopoly.

This could explain much of the gross difference between countries, if you've followed my arguments based on the tradables/non-tradables model of exchange rate determination. Also, The Economist themselves warn that the Index should only be relied upon when comparing economies with similar income levels, a finding that is also derived from the same model - high-income countries have higher price levels, and would therefore have stronger currencies in relation to lower-income economies. Looking at the index, we do indeed find developing economies in general having derived-PPP levels lower than that of advanced economies.

The epiphany I was talking about earlier focused on something quite different, which could also strengthen the argument against a Big Mac Index as a PPP measure. When I was a student in London in the late 1980s, I was struck by the fact that Coca-Cola and many other global food and beverage brands had very similar prices to Malaysia's (admission: I'm a Coke addict) - on the face of it, this would imply the intuition behind the Big Mac Index was correct.

But looking at McDonalds' menu prices a different story emerged: Big Macs were indeed more expensive in the UK (and not just in London). Here's the kicker. While Big Macs were more expensive, Filet o'Fish were actually cheaper in the UK than in KL, on par with the humble Hamburger.

What that suggests to me are a few additional economic explanations, over and above the conventional critique:

1. The difference in prices between low-income and high-income economies can also be attributed to differences in the ability to purchase higher-protein diets. As countries shift from low-income to high-income, the protein intake of the population increases raising demand (and prices) for beef.

2. Differences in prices can also be attributed to consumer preferences for different types of protein. Honestly, how often do you see Asians eating beef as compared to chicken, fish or pork?

3. As a corollary to the above, access to alternative supplies of protein (for instance, access to the seas) would also impact beef demand.

Just as important as these factors are that Big Macs are not tradable - there's no price arbitration across borders because Big Macs are a perishable good, unlike for instance a can of Coke. Also, McDonalds is a multi-national corporation with a globally-recognisable brand. To me that suggests that it also likely practices price differentiation across markets, which is a characteristic of monopolies.

So there are quite a few more factors involved than just the conventional economic explanations for differences in purchasing power based on the Big Mac Index, and hence implied-PPP evaluations of exchange rates. A Filet O'Fish Index for instance could paint a very different picture of PPP between East and West.

Proving all these formally might take some doing, but I think I'm going to make a stab at it. It'd make for a decent publishable paper.