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Purchasing Power Parity (PPP) Deviations: the Case of H&M Purchasing Power Parity (PPP) Deviations: The case of H&M. BACHELOR THESIS WITHIN: Economics CREDITS: 15 PROGRAMME: International Economics AUTHORS: Sofia Chen Ruoshui He JÖNKÖPING May 2020 Bachelor Degree Project in Economics Title: Purchasing Power Parity (PPP) Deviations: The case of H&M. Authors: Sofia Chen and Ruoshui He Tutor: Andrea Schneider Date: 2020-05-18 Key terms: Purchasing power parity, law of one price, homogenous products, price settings, H&M. Abstract The theories of the law of one price and purchasing power parity are thought to hold almost exactly in financial market, but it seems less likely to occur in international trade where arbitrage opportunities take place. The purpose of this study is to test whether the purchasing power parity holds for commodities in various national markets, for which a quantitative method is followed. For identical goods, the prices should be equal across countries. In fact, the prices vary significantly across ‘truly homogenous’ goods within a product group. The finding suggests that differences in productivity and value-added tax do have significant positive impacts on price settings. As a consequence, purchasing power parity definitely does not prevail as well as law of one price does not. Further studies can use these findings to examine the extent and permanence of violations of the law of one price. i Table of Contents 1 Introduction ........................................................................................ 1 2 Theoretical Framework ...................................................................... 3 2.1 The Law of One Price .................................................................................... 3 2.2 Purchasing Power Parity ................................................................................ 3 2.2.1 Absoulte PPP ...................................................................................................................... 4 2.2.2 Relative PPP ........................................................................................................................ 6 2.3 Purchasing Power Parity Deviation Puzzle ................................................... 7 2.3.1 Trade Barriers ..................................................................................................................... 7 2.3.2 Non-tradable Inputs ........................................................................................................... 8 2.3.3 Value-added Tax ................................................................................................................. 9 3 Literature Review .............................................................................. 11 4 Empirical Analysis ........................................................................... 12 4.1 Data .............................................................................................................. 12 4.2 Empirical Models ......................................................................................... 19 4.3 Empirical Findings ...................................................................................... 21 4.4 Limitations ................................................................................................... 26 5 Conclusion ........................................................................................ 27 References .............................................................................................. 28 Appendix ................................................................................................ 33 ii Figures Figure 1 The Effect of Tariff in Export and Import Countries............................................7 Figure 2 The Tariff Rate of Ten Countries...............................................................................8 Figure 3 Product Image..............................................................................................................12 Figure 4 The VAT Rate Distribution in Ten Countries........................................................16 Figure 5 The Silk Shirt Dress Price Distribution....................................................................17 Figure 6 Comparison of The H&M Index (Silk Shirt Dress) with The Big Mac Index...17 Figure 7 Comparison of The H&M Index (Patterned Jeans) with The Big Mac Index...19 Figure 8 Ten Countries Productivity........................................................................................20 Tables Table 1 The Big Mac Index.........................................................................................................5 Table 2 Product Description.....................................................................................................12 Table 3 The Products Prices List in Ten Countries...............................................................13 Table 4 Exchange Rate...............................................................................................................14 Table 5 The Products Prices List in Common Currency......................................................15 Table 6 The Products Prices List in Common Currency without VAT.............................16 Table 7 The Regression Output for Model One....................................................................22 Table 8 The Regression Output for Model Two....................................................................23 iii 1 Introduction With the rapid growth of electronic commerce in the globalized world, online shopping has become one of the most convenient ways to make comparisons of similar products in different markets. This can be credited to consumers who are always able to convert prices into another currency by which to determine whether it is profitable to purchase goods in the particular market. Currently, H&M is one of the most visited fashion sites in the world1. As a consumer, if we solely look at the price of one identical good for say, Jersey T-shirt sold by H&M in Sweden and China. In fact, the product sold more expensive in China than in Sweden when measured in a common currency. This phenomenon, however, is related to the theory of purchasing power parity. Purchasing power parity (PPP) is one of the oldest and most fundamental economics concepts (Krugman, Obstfeld, & Melitz, 2012). It states that the price levels between any two countries should be identical after converting them into a common currency. As a theoretical proposition, it is widely used in the economic literature to analyze and to predict exchange rate movements as well as to serve as conditions under which international markets adjust to attain long-term equilibrium. The law of one price (LOP) does not focus on the aggregate price level. It points out that the price of each identical good is the same in different markets when expressed in a common currency. If the law of one price leads to the equalization of a commodity price between two markets, then it seems reasonable to conclude that purchasing power parity that describes the equality of market baskets of goods across countries should also hold. Ideally, the test of LOP and PPP is to compare the prices of two transactions, where the buyer is the only difference in the characteristics of the transaction. In practice, the assumption of homogenous goods is almost violated in available data or on complex products to some extent. The study of Goldberg and Verboven (1998) uses a complex product, car, to examine PPP deviations. The selected product, however, is usually not exactly identical in different countries. Subsequent research attempted to focus on homogeneous products of specific companies that are sold in various national markets. The most well-known study is the Big Mac Index published by The Economist in 19862, which was treated as an example of "truly homogenous" products since the Big Macs with the same taste, ingredients, and appearance sold by McDonald’s everywhere. This paper continues to use price information on various identical products sold by a single firm that provides standardized services in various national markets in a standardized environment in undertaking this research. This paper chose the clothing industry to investigate the nature of price differences. This is due to the fact that it plays a decisive role in past economic development. Palpacuer, Gibbon and Thomsen (2004) claim that the clothing industry has played several vital roles in the development process. It reduced unemployment by targeting unskilled labor, satisfied the needs of a large number of people through mass production as well as created capital for more technical demanding production in other sectors. A large number of clothing exports provided funding for the import of more advanced technologies. Furthermore, it is significantly important for employment and growth in developing countries. Hence, one of the well-established firms in the clothing industry - H&M has been selected. 1 H&M Group - https://hmgroup.com/content/dam/hmgroup/groupsite/documents/masterlanguage/Annual%20R eport/HM_Annual%20Report%202019.pdf 2 The Economist - https://www.economist.com/news/2020/01/15/the-big-mac-index 1 H&M is founded in 1947 in Västerås, Sweden. During the past 70 years, it gradually developed into one of the most famous worldwide clothing companies. Nowadays, H&M operates in 74 countries with over 5,000 stores under various company brands3. Their products are classified into several departments, including categories of clothes, cosmetics, home decorations, and
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