Why a Haircut Costs Five Dollars in One Country and Fifty in Another
Purchasing power parity says exchange rates should equalise the cost of identical goods. They do not, persistently, and the reasons why are more informative than the theory.
The Theory
Purchasing power parity holds that exchange rates should adjust so that identical goods cost the same everywhere once converted to a common currency.
The reasoning is arbitrage. If a good is cheaper in one country, traders buy it there and sell it elsewhere, and that activity pushes prices and the exchange rate toward equality.
Why It Fails in Practice
The arbitrage argument requires goods to be tradeable, and most of what people spend money on is not.
| Category | Tradeable | Price converges |
|---|---|---|
| Electronics | Yes | Largely |
| Commodities | Yes | Closely |
| Housing | No | Not at all |
| Haircuts, restaurants | No | Not at all |
| Healthcare, education | Mostly no | Not at all |
You cannot import a haircut. Services and housing make up a large share of consumption, and their prices are set by local wages and local supply, not by international arbitrage.
The theory works for the things you can put in a shipping container and fails for everything else, which is most of what people actually buy.
Why Poorer Countries Are Systematically Cheaper
There is a structural reason price levels are lower in lower income countries, and it is not simply that they are poor.
Productivity differences between countries are much larger in tradeable goods manufacturing than in services. A factory worker in a rich country may be several times more productive than one in a poor country, while a barber is roughly equally productive everywhere.
Wages within a country tend to equalise across sectors, so high manufacturing productivity in a rich country pulls up service wages too, even though service productivity did not rise. The result is that services are expensive in rich countries and cheap in poor ones, systematically.
This effect explains why comparing incomes at market exchange rates overstates the gap between countries, and why adjusted comparisons are used for welfare questions.
When to Use Which Conversion
The practical rule follows directly. For questions about living standards, what people can actually consume, use purchasing power adjusted figures. For questions about international transactions, debt denominated in foreign currency, or the size of an economy in world markets, use market exchange rates.
Using the wrong one produces confident nonsense. A country debt burden is not eased by its haircuts being cheap, because creditors are paid in currency at the market rate.
The Long Run Version
The theory has more force as a long run anchor than as a prediction of current rates. Over long periods, currencies of countries with persistently higher inflation do tend to depreciate roughly in line with the inflation difference, which is the relative form of the idea.
Even here the relationship is loose and slow. Exchange rates can deviate for a decade or more, driven by interest rate differentials, capital flows, and expectations, none of which have anything to do with the price of goods.
Why the Deviations Matter
A currency well above its purchasing power level makes exports uncompetitive and imports cheap, which pressures domestic manufacturing. A currency below it does the reverse, supporting exporters while raising the cost of imported inputs and energy.
Those effects are real and they persist far longer than the theory implies they should, which is why the deviation is a legitimate subject of policy attention rather than something that self corrects promptly.
The Bottom Line
Purchasing power parity is a useful benchmark and a poor forecast. It holds reasonably for tradeable goods and not at all for services and housing, which is why price levels differ systematically with income. Use adjusted figures for living standards and market rates for anything involving actual cross border payment.