Purchasing power parity raises worries

“…we should be in “broad-exploration” mode.” (Caballero 2010)

The Penn Effect is that prices of goods and services in developed countries (DCs) are, after using market exchange rates, substantially higher than those in less-developed countries (LDCs).

Following Froot and Rogoff (1995), the Economic Survey of India, 2010-11 discussed ‘catch-up inflation’ in the country; this was prepared under the guidance of then Chief Economic Adviser, Kaushik Basu. The idea is that as India develops and shifts from being an LDC to becoming a DC in future, prices will rise (over and above what is implied by the more familiar inflation).

It may be problematic to make international comparisons using PPP that is based on observed prices, and why effective prices should be used instead. While it is true that an international comparison on the basis of market exchange rates can underestimate the GDP of a country like India relative to that of a DC, the use of exchange rate based on PPP can overestimate the GDP in India

This idea of ‘catch-up inflation’ has hardly been accepted among economists. It is, however, interesting that the idea of ‘catch-up inflation’ within a developing economy over time is consistent with the accepted notion of price-rise as we move from LDCs to DCs (the Penn Effect) at a point of time. This suggests that the proponents of the Penn Effect should either accept the idea of ‘catch-up inflation’ or they should question the Penn Effect more seriously than they have so far.

Kaushik Basu has been consistent: he accepted both the Penn Effect and the ‘catch-up inflation.’ But others have not been very consistent. They have not rejected the Penn Effect even while they have been lukewarm about the idea of ‘catch-up inflation.’

Next, consider the magnitude of the Penn Effect. Prices are estimated to be, on an average, more than three times higher in the US than in India (World Bank, 2015). This price differential is huge. It is true that a large proportion of GDP (gross domestic product) consists of non-tradable goods and services which cannot be shipped from India to US, and so the huge price differential can indeed persist in equilibrium.

However, the huge price differential raises another set of questions. This price differential can be very attractive to tourists from US. But there are very few tourists coming to India. Also, the price differential can be attractive to migrants who had initially moved out of India. In their retirement years, a good proportion, if not all, of the migrants could return home – but this is not true.

The prices in US are, as mentioned earlier, more than three times the prices in India. Let us consider this number in perspective. Pension funds in US are going through a crisis as they have large unfunded liabilities (Marin 2013). The size is still debated. If the shortfall is a quarter of the liabilities,

then on the one hand, a shortfall of 25% is viewed as a situation of a crisis. On the other hand, there is an opportunity to get 200% more by shifting to a country like India! It is true that there can be home bias and so there can be reluctance on the part of the retired Americans to shift to India. However, can this be so strong as to overcome the temptation of foregoing 200% higher pension?

There are other examples as well. Financially constrained students in US hardly ever consider India for higher education even though the fees can be far less than one-third (due to available subsidies in India). The usual explanations lie in non-economic factors. There is indeed merit in such explanations. However, there can be a simple economic reason; while the observed prices are indeed low, the effective prices are, in fact, not very low in India.

Observed vs. effective prices

It is usual to view only the money paid for a good or service as the price, and rightly so - in the context of DCs. However, in LDCs, there can be an additional price in forms other than money. So, the effective prices in LDCs are not as low as the observed prices are (Singh 2017). The basic reason briefly is as follows.

There are some well-known features of an LDC; these are usually viewed as part of the narrative that describes an LDC, and nothing more from the viewpoint of pricing in LDCs. However, pricing in LDCs can be different and more complex than in DCs. An important manifestation of the complexity is that the money price is not the only price paid for goods and services. There are other considerations; these make the effective prices higher than the observed prices.

There can be various adjustments to observed prices, which are required to arrive at effective prices in India (and in LDCs more generally). A brief explanation is as follows. First, it takes more time and trouble to buy goods and services in India. For example, an Uber ride is much cheaper monetarily in India but it typically takes much longer to cover the same distance – thanks to the slow and chaotic movement of traffic. So, the time-adjusted price in India is not as low as the observed price is.

Second, there is often a negative externality, which is not accounted for in the observed price. Hawkers operate on the roadside; their prices are low but their operations can slow down the traffic movements and cause difficulties to very many people every day. While it can be cheap and convenient for a homemaker, the same feature can be troublesome for the spouse and other family members who use the road for commuting and making a living. So, the ‘externality’-adjusted price is not as low as the observed price.

Third, there is often a risk in purchases. For example, medical charges can be relatively low in India but there is a question mark about the competence of a medical practitioner (and even about the arrangements in many hospitals). So, the risk-adjusted price can be higher than the observed price. Fourth, quality is low in India. This is well-known but not adequately appreciated.

For example, the quality of higher education is relatively low in India (this should not be confused with the quality of screening of good students, which is where the comparative advantage of some reputed institutions of higher education in India lies). The students eventually pay a heavy price in terms of the higher (private or social) returns that are foregone because the quality of education is low.

Thus, the quality-adjusted price of education can be high in India. The literature on the Penn Effect is primarily a part of International Economics. It appears that there is a need for a closer look from the angle of Development Economics as well.

Using adjusted-PPP

If prices are more than three times higher in US than in India, it follows that the exchange rate based on purchasing power parity (PPP) is less than Rs. 21.53 per dollar (21.53 =64.59/3, where 64.59 is the market price of dollar in terms of Rupees on 16 June 2017). Now the concept of PPP is basically sound. However, it uses observed prices of goods and services (Sarno 2008, Zhang 2017).

If effective prices are used instead, this leads to, what we may call, the theory of adjusted-PPP. The significance of using adjusted-PPP is as follows. While it is true that an international comparison on the basis of market exchange rates can underestimate the GDP of a country like India relative to that of a DC, the use of exchange rate based on PPP can overestimate the GDP in India. It may help to consider adjusted-PPP in this context for a fair comparison.

("Reprinted with permission from Ideas for India, www.ideasforindia.in)

By Dr Gurbachan Singh