VOL. 3, NO. 9 SEPTEMBER 2008­­ EconomicLetter Insights from the FEDERAL RESERVE BANK OF DALLAS The Big Mac: A Global-to-Local Look at Pricing by Anthony Landry The global, national, Readily tradable goods—oil, chemicals, metals and agricultural regional and local commodities, for example—tend to sell at world prices. Nontradable goods factors that shape and services—housing, cab rides and such personal services as haircuts— price-setting behavior are largely insulated from global competition, and their prices can vary from are complex, even for place to place. a relatively simple Whether goods are tradable, nontradable or somewhere in between product that’s neither influences the international transmission of price fluctuations. Rising prices easily tradable nor in tradables are highly likely to spill across borders, while rising prices in wholly nontradable. nontradables are not. A better understanding of factors that determine prices should help the Federal Reserve and other central banks incorporate foreign price movements into monetary policy decisions. That brings us to the Big Mac and what it can teach us about pric- ing. McDonald’s iconic hamburger is a tiny bit of the world economy, but it’s the ingredients of the Big Mac are the adjusted for exchange rates? Most same wherever it’s sold.1 Other global explanations of international price products could be used for a prop in gaps focus on factors that enable this exercise—a Coca-Cola, a Starbucks price discrimination to persist. Markets coffee, an iPod—but, over the years, don’t bid these price differences away the Big Mac Index has been a quick because of the high costs to arbitrage, guide to prices in many countries. the profit from buying in lower price Most explanations In July, The Economist presented markets and selling in higher price Big Mac prices in local currencies and ones. of international U.S. dollars for 45 countries, show- One of these factors is the cost of ing a range from $1.70 in Malaysia to moving goods across borders. The Big price gaps focus on $7.88 in Norway.2 The U.S. fell into the Mac itself isn’t tradable, but many of middle of the pack, with an average its ingredients are. Transportation costs factors that enable Big Mac price of $2.99 (see abbrevi- for frozen beef patties, cooking oil, ated list, Table 1). These differences special sauce, sesame-seed buns and price discrimination are typical of the price disparities The other tradable Big Mac ingredients can Economist has found over more than create price gaps across countries. The to persist. two decades. added costs aren’t trivial. A 2001 study, Why do Big Mac prices vary from for example, found that transporta- one nation to another, even when tion raised import prices 7 percent for Table 1 often used as a rough gauge of relative prices across countries. Big Mac Prices Vary Across the World Since 1986, The Economist maga- zine has been publishing a Big Mac Country Price in local currency Exchange rate Price in US$ Index, comparing the hamburger’s Malaysia 5.50 3.20 1.70 international prices. The index shows China 12.50 6.83 1.83 how much Big Mac prices vary from Thailand 62.00 33.40 1.86 one country to the next. What’s less Pakistan 140.00 70.90 1.97 well known is the extent to which Big Indonesia 18,700.00 9,152.00 2.04 Mac prices diverge across the U.S., South Africa 16.90 7.56 2.24 regions, Texas and even Dallas. The Egypt 13.00 5.31 2.45 Russia 59.00 23.20 2.54 reasons for the disparities help us sort Japan 280.00 106.80 2.62 out how international, national, region- Saudi Arabia 10.00 3.75 2.67 al and local factors shape prices—at U.S. 2.99 n.a. 2.99 least for one product. Chile 1,550.00 494.00 3.13 South Korea 3,200.00 1,018.00 3.14 World Prices Mexico 32.00 10.20 3.15 The Economist concocted the Big Australia 3.45 1.03 3.36 Poland 7.00 2.03 3.45 Mac Index with a sly wink and didac- Argentina 11.00 3.02 3.64 tic purpose—“to make exchange-rate Canada 4.09 1.00 4.08 theory more digestible.” The Big Mac Turkey 5.15 1.19 4.32 stood in for the market baskets of Britain 2.29 2.00 4.57 goods and services that economists use Brazil 7.50 1.58 4.73 to measure purchasing power parity, Euro area 3.37 1.59 5.34 an alternative to market exchange rates Switzerland 6.50 1.02 6.36 Norway 40.00 5.08 7.88 for comparing output or consumption in different countries. NOTES: Chart reflects a sampling of the 45 countries surveyed and includes the highest and lowest Big Mac prices. Big Mac The attractive feature of the Big prices are taken from The Economist, July 26, 2008. The U.S. price is an average of the prices sampled for this article. Mac as an indicator is its uniform SOURCES: The Economist; Federal Reserve Bank of Dallas. composition. With few exceptions, EconomicLetter 2 FEDERAL RESERVE BANK OF DALLAS FEDERAL RESERVE BANK OF DALLAS EconomicLetter meat, 6 percent for dairy products and done with a regression analysis for Big 16 percent for vegetables.3 Mac prices and per capita income for The costs imposed by tariffs, countries in The Economist’s Big Mac quotas and other trade barriers can survey (Chart 1). For the most part, contribute to price disparities between the Balassa–Samuelson explanation countries. Tariffs directly affect import holds: The analysis shows that Big prices but only indirectly affect import Mac prices are higher in countries with quantities through price increases’ higher per capita incomes. International dampening impact on consumer In economic terms, Big Macs demand. Quotas, on the other hand, aren’t exceptional. International trans- transportation costs, directly restrict import quantities but portation costs, trade barriers and only indirectly affect import prices by income disparities help explain why so trade barriers and creating artificial scarcity. many other goods and services sell at Nearly all governments have different prices in different countries. income disparities help restricted imports to protect important None of these factors are likely to go domestic industries from international away any time soon, so we can expect explain why so many competition. Agricultural trade faces international prices will continue to many barriers designed to benefit vary. For the Big Mac, though, that’s other goods and services domestic farmers, and quotas and tar- not the end of the story. iffs hamper McDonald’s beef imports sell at different prices in many parts of the world.4 U.S. Prices However, transportation costs If price deviations were solely due in different countries. and trade barriers only impact the Big to international transportation costs, Mac’s traded components. By one esti- trade barriers and income disparities, mate, just 6 percent of the Big Mac’s Big Macs should sell at a constant price comes from the cost of its ingre- price within the U.S. dients.5 This implies that, at most, 18 That isn’t the case. cents of a $2.99 U.S. Big Mac can be No U.S. magazine prints a coun- directly tied to factors that influence terpart to The Economist’s Big Mac the cost of tradable goods. The remaining costs come from the nontraded inputs used in making Big Macs—such as rents and wages, Chart 1 which vary widely from one country to Rich Countries Pay More for Big Macs another. These differences in operating costs show up in Big Mac prices. Big Mac prices In 1964, Bela Balassa and Paul US$8 Samuelson suggested that prices of nontraded goods and services are 7 higher in rich countries.6 Interestingly, their reasoning begins with the trad- 6 able sectors, which are more produc- 5 tive in rich countries than in poor ones. Tradables’ higher productivity 4 influences rents and wages in all sec- tors as firms in both tradable and non- 3 U.S. tradable sectors bid up the prices for real estate and workers. 2 Simply put, nontraded inputs 1 raise prices in rich countries relative to 0 US$10,000 20,000 30,000 40,000 50,000 60,000 70,000 poor ones. Looking at the relationship Per capita income between prices and income provides a NOTE: The t statistic for the coefficient of per capita income is 6.66. test for the Balassa–Samuelson propo- SOURCES: The Economist, July 26, 2008; Federal Reserve Bank of Dallas; World Development Indicators, World Bank, 2005. sition. For our purposes, this can be EconomicLetter FEDERAL RESERVE BANK OF DALLAS FEDERAL RESERVE BANK OF DALLAS 3 EconomicLetter Index, so we collected Big Mac prices Philadelphia (Table 2). By region, for 150 McDonald’s across the U.S. the average ranges from $2.77 in the during the week of April 20, 2008. The South to $3.22 in the Northeast. restaurants represent a range of loca- Big Mac prices at 12 locations tions, including airports, suburbs and across Texas and at 12 Dallas-area downtowns, shopping malls and ser- restaurants echo the theme of price vice roads. They’re grouped into four disparities (Table 3). A Fort Worth Big regions—Northeast, Midwest, South Mac was a bargain at $2.35. Just 30 and West. miles to the east in Dallas, the ham- Even within the U.S., Big Mac burger was the most expensive in the prices show large disparities.