Absolute purchasing power parity

The absolute purchasing power parity theory (APPPT) predicts that price levels will be the same across countries. Recall that the law of one price states that the same products will have the same prices everywhere. The APPPT applies the same logic to all prices in the country. Basically, it predicts that the cost of living across countries should be the same.

It is clear to anyone who has visited a foreign country that the APPPT does not hold. Switzerland is much more expensive than the U.S. and the U.S. is more expensive than Mexico. Also, these differences in price levels are not temporary but last a long time.

Why aren’t prices the same everywhere? For one, in every country there are many so-called non-tradable goods and services. These are products that are not imported and exported and there is less reason for their prices to become the same across countries. Take, for example, the price of a haircut. No one (almost) would go from Switzerland to the U.S. to have a haircut because haircuts are cheaper in the U.S. That means that haircut prices will remain different. If there was international trade for haircuts, their prices would gradually become the same.

Besides that, high transport costs could make the shipping of products very expensive. Different countries could have different taxes and tariffs. All of those prevent price levels from equalizing.

Even if it doesn’t hold, the APPPT is a useful way to think about international prices. We use it as a benchmark to start explaining why the cost of living is different around the world.

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