Purchasing Power Parity (PPP): Challenges and Limitations

The basic concept of purchasing power parity theory or PPP relates to the purchasing power of a dollar. PPP relies on the price of goods and services remaining constant across comparisons, often referred to as the law of one price. Problems arise in PPP theories because issues such as transportation costs factor into the price of goods and services, causing them to vary across comparisons.

Transportation Costs

When a manufacturer has to transport a good farther to reach a market, the retailer often adds the transportation cost to the final price of the good. The farther away the good has to travel from its original manufacturer, the higher the price for the consumer living in that market. Due to the higher transportation costs, the purchasing power of the dollar for the consumer living in the market further away is less than the purchasing power of the dollar for the consumer living in a closer market. The price for the same good in different markets is not constant and the PPP law of one price does not hold.

Demand

Manufacturers often adjust the prices of goods according to the demand in specific markets to maximize profits. Economists call this practice pricing to market. When there is a high demand for a product in a specific market, manufacturers increase the price. When there is low demand, the manufacturer decreases the price. The PPP law of one price does not hold here because consumers living in high-demand areas have less purchasing power since the product is more expensive. Consumers living in low demand areas have increased purchasing power because the price for the same product is less expensive

Taxes

Taxes cause the final price of the same good to vary in different markets. In an area where sales taxes are higher, the consumer has less purchasing power because the final price of the good is higher. In areas where sales taxes are lower, the consumer has more purchasing power because the final price of the good is lower. The law of one price does not hold because of the differentiation in prices due to sales taxes.