The Big Mac index is a periodic survey made by The Economist to measure purchasing power parity between countries. It uses local Big Mac prices as the benchmark.
The index was first introduced in 1986, and while it was a convenient way for the general public to understand the topic of purchasing power parity, its results were limited and unreliable.
Purchasing Power Parity (PPP)
According to economic theory (though it’s not a consensus), the exchange rate between two currencies is equal to the ratio of the currencies’ respective purchasing power, which means that it would cost exactly the same to buy a basket of goods in two different countries after conversion of the currencies. For instance, if a Big Mac costs $2.00 in the U.S. and the currency rate between the U.S Dollar and the Chinese Yuan is 1:6, we would expect it to cost 12 Yuan in China. If the price of a Big Mac is 14 Yuan, it implies a PPP currency exchange of 1:7, which means that the Yuan is expected to weaken from the current 1:6 to the PPP 1:7 in the long run.
The concept of purchasing power parity allows us to estimate the real value of currencies in the long term. PPP also allows estimating the GDP of a country without the influence of fluctuations in exchange rates.
So, Americans had to determine a clear way to explain the topic. They came out with a true American symbol: the Big Mac.
Why Big Mac?
The Big Mac was chosen because it is available in almost every country around the world. It is widely used very affordable. Its popularity and affordability were considered to make the comparison reliable as opposed to other ways to compare nations’ currencies that did not handle goods as available as the Big Mac.
As millennials have begun dominating the economy in the last few years, McDonald’s sales are going down, and a Big Mac, which was once the perfect meal for people all across the globe.
Problems with the Big Mac index
The Big Mac is a product of McDonald’s and actually differs around the world in terms of size and ingredients (in India, chicken is used, as no beef is sold at local McDonalds). McDonald’s may decide to price its hamburgers differently across nations; for example, if McDonald’s wants to penetrate a new market or increase its market share, it might decide to lower the price of a Big Mac, which has nothing to do with the purchasing power of the local population. Prices can be different even within the same country—prices in big cities are normally higher than prices in rural areas. Furthermore, Big Macs do not represent transferable goods that can be shipped as is, so we cannot expect prices across borders to be the same (in a perfect economic world, such goods are supposed to cost the same across borders if they can be relocated).
In general, the popularity of the Big Mac and McDonald’s varies between countries. Different demands can affect the price, thus hurting the reliability of the index. Local taxes can also affect the price, and other factors can change the price from its anticipated equilibrium.
Over the years, economists have tried to handle the inherit problem with the Big Mac index and produced several other indices. An interesting one was the iPod index.
This index was seen to solve some of the problems of the Big Mac index, since the iPod is manufactured at a single place, and thus we could expect more consistent global pricing, but shipping costs vary between countries, and local taxes for electronic products can change the price dramatically.
McDonald’s does not have any branches in most African nations, which led an African research firm to suggest the KFC index for prices of local chicken buckets. The index obviously suffered from the same limitations that affect the Big Mac index.
Many other indices were developed over the years. Some represented a real effort to compare purchasing power parity between countries, while others were mostly just a humorous way to tackle the problem.
Lately, a new index was born—The Chai Latte Global Index, which compares Starbucks Chai Latte prices worldwide. The index compares prices of the increasingly popular chai latte across the globe, and results have been quite similar to those of the Big Mac index. Countries with a currency that seems undervalued in one index usually have it overvalued in another one. One notable example of differences is China, where Chai Latte is very expensive, but Big Macs are relatively cheap.
The Chai Latte index cannot escape from the same problems—belongs to one company, affected by local taxes, and does not exist everywhere. A few years ago another economist used Starbucks for an index with high latte prices, but even coffee is not as global a product as you might think. For example, in India, they prefer chai latte. . . .
So which index will be the savior?
Economists are still trying to find an index that will be the perfect answer to not only explain purchasing power parity but also be able to accurately predict overvaluation and undervaluation of currencies. The Big Mac has been generally satisfactory, but it is limited, as all goods are limited. Optimal goods would be those that are popular worldwide. They would include the same taxes and shipping costs, the same ingredients or materials, and cannot be priced differently by any company or government. As you can imagine, such goods do not exist. Hamburger or coffee is probably the best that you can do, but as of 2017, no goods are used the same way in every place throughout the world. At least they don’t charge us for air!