Background Note Overseas Development June 2010 Institute Purchasing power parity measures: advantages and limitations By Samuel Moon, Sheila Page, Barry Rodin and Donald Roy iscussion and analysis on international how the people whose incomes are being measured comparison using Purchasing Power Parity behave, and the trade-off between the appropriate- (PPP) have been somewhat neglected in ness of the measure and the costs of improving it. recent years. With recent shifts in economic Starting in the 1990s, the major restructuring of pro- Dgrowth and constantly changing poverty dynamics, duction in eastern Europe, the adoption of numerical as well as forthcoming major evaluations of progress targets in development (reducing ‘less than a dollar a on the Millennium Development Goals (MDGs), it is day’ poverty), and the growing economic and political an opportune time to revive the debate. This paper power of countries normally considered ‘poor’ (espe- examines what PPP tries to do, some of the problems cially China) have increased interest in this subject. of measuring it and using different measures, and New and revised international data from the 2005 why it matters. round of the International Comparison Programme (ICP) published in 2008 meant that estimates of eco- Why we need PPP nomic activity measured at purchasing power parity Policy-makers, researchers, businesses and consum- (PPP) are now available for the vast majority of coun- ers all want to compare incomes and spending, often tries, including China for the first time. This has led to when prices are different or changing. The comparison new comparisons, but also to growing awareness of of incomes and measurement of changes in incomes the limitations of the data. are essential tools in analysing the success of eco- nomic policies and, in particular, in asking questions about development. Observers have a wide range of Box 1 purposes for such comparisons, so there is no single A consumer price index, CPI, is a tool to measure answer to what is the ‘right’ measure of prices to use, changes in prices of a set basket of goods over time, or and problems in the data and methodology mean that differences in the prices of that same basket of goods in there may be no single answer even for a specific ques- different regions. tion. This paper explores how estimates of incomes Consumer preferences are captured using a household and prices can be calculated and gives examples of survey that measures expenditure patterns over different why choosing the best indicator matters. It surveys a demographics. range of different purposes for comparing incomes and Purchasing Power Parity, PPP, is a mechanism for suggests some of the decisions that must be made in accounting for different relative costs of goods when choosing how to make different types of comparison. undertaking comparative analysis of expenditures and In short, users must define clearly what they want to incomes in different countries. know, what they already know or can assume about The Overseas Development Institute is the UK’s leading independent think tank on international development and humanitarian issues. ODI Background Notes provide a summary or snapshot of an issue or of an area of ODI work in progress. This and other ODI Background Notes are available from www.odi.org.uk The authors are members of the International Product and Income Comparison Group (IPIC), an informal group established in 1990 to study methodologies and uses of PPP measures. For further information, contact Sam Moon ([email protected]). ODI at 50: advancing knowledge, shaping policy, inspiring practice • www.odi.org.uk/50years Background Note Measuring prices In order to compare incomes between two groups When comparing incomes across time or across coun- with different spending patterns, some method of tries or even within countries, the first set of choices adjusting these must be found. This can be done by to be made is about which prices go into the raw data. calculating an average (for which there are different Goods and services vary in quality; prices often can methods) or by doing two comparisons, using each vary drastically by season, but in different ways in group’s pattern. These will give different answers, and different parts of a country; goods can be bought in can give different rankings. The problems become different quantities from different suppliers in differ- more complex when there are more than two groups ent locations (and all these may be correlated with (for example all the countries in the world) and even the buyers’ incomes); they are bought in different more complex if various levels of analysis are needed proportions by different buyers (including by the dif- (for example, comparing members of a group such as ferent groups to be compared); the access to markets the European Union among each other and then, as a often varies for different demographics of the popula- group, with the rest of the world). tion for a variety of reasons. There are, therefore, both For comparisons within one group, with relatively price differences for the same commodity or service small changes in price, relatively small changes in and differences in the importance of the same com- income can be measured. For different populations modity for different consumers, within a country and with different compositions of spending any compari- between countries. son will vary depending on the method of accounting The data require detailed price and household for the differences. For large differences or changes in surveys to determine what the group of interest buys, price, assumptions must be made about how substi- and where and how they buy it. How detailed do they tution from a high priced good to another affects the need to be? This is partly a matter of judgement, to comparison: substitution will lower the prices paid, be revisited as more information becomes available apparently increasing income, but will reduce the per- (how large are the differences, so how many different ceived real income because the consumer preferred types of observation are needed?) and partly of cost. the higher price good. Developing consumer price indices for a compre- hensive analysis or even for a particular group in a Examples of using income comparisons to given country may be extremely difficult and/or costly. answer development questions To give an example, there is often a focus on deter- Which countries have the highest or lowest total mining the income dynamics of the rural poor. But national incomes? Consumer Price Surveys are often only taken at urban If this is a question about economic power, then trading centres. While the rural population may have spending power within each country may not be rele- to go into these trading centres to access some goods, vant, so price comparisons are unlikely to be needed. they will be exposed to additional (and highly variable) But if it is a question about which countries have costs of transport and market knowledge. For other achieved most or which should contribute most to goods, the rural population may largely produce their global needs, whether formal contributions to interna- own food supplies, and ‘farm gate’ food prices are not tional organisations or through aid, security spending, likely to be measured adequately by a Consumer Price etc., people may want an answer based on the level of Index (CPI) observed at trading centres. Preferences per capita incomes, adjusted for different prices, i.e. differ too. One region, tribe or gender, for example, PPP calculations. may consistently choose to consume a basket of food One topical reason for such comparisons is to goods that diverges from the national average. identify how large current differences in income In Uganda, the national poverty line is calculated levels are in order to identify how the contribution with a basket of goods that gives a heavy weighting of currently low-income countries to climate change to matooke, a type of green banana that is traditional will increase as their incomes ‘converge’ on those of in much of the central area of the country, but is rela- high-income countries. The Intergovernmental Panel tively more expensive and less calorie efficient than on Climate Change (IPCC) has used estimates of other staples. Most of the population elsewhere in the economic activity based on market exchange rates country prefer staples that are naturally cheaper per rather than on purchasing power parities. These calorie, and therefore require a lower overall income overstate both significantly and systematically the to afford the basket of food providing the same calorie gap in wealth between rich and poor countries and levels. This may have systemic effects on over-esti- thus the amount of economic growth required to mating poverty in areas that do not favour matooke, achieve convergence over the current century. PPP but the example raises questions about the definition estimates of economic activity would form a much of poverty, which is addressed later in this paper. sounder basis for economic projections, and in this 2 Background Note Case Study 1: Use of cost of living indices/PPPs when managing international assignments In the past 20 years the international mobility of staff has been seen as vital for the success of many organisa- tions’ global operations. A key consideration when resourcing these activities is assessing pay for expatri- ates as cost effectively as possible. Although there are many criteria and objectives to consider when formulating pay methods for interna- tional assignees, the most common approach ensures that pay is at least equitable or consistent with their home country peers. In other words, home country living standards should be protected for economic vari- ables such as differences in living costs and levels of taxation, which still exist even in Western Europe.