When Jim Delligatti created the Big Mac in 1967, he might have had no idea that The Economist would use the price of that hamburger to gauge a currency’s purchasing power.
Since 1986, The Economist has been collecting the average Big Mac prices from McDonald’s in 56 countries and the Euro area for its Big Mac index.
In July, a Big Mac cost Indonesians around Rp 34,000 and Americans around $5.71, according to the magazine. By this comparison, Rp 5,954.46 worth as much as a dollar.
But the actual exchange rate for the rupiah stood at Rp 14,435 a dollar for that month, according to the magazine, quoting data from Reuters.
The difference between the implied exchange rate as measured by Big Mac prices and the actual exchange rate suggests that the rupiah was undervalued by around 58 percent against the dollar.
Comparing Big Mac prices in Indonesia and the US is a common application of the purchasing power parity (PPP) theory. Based on this theory, the price levels of a Big Mac in both countries are expected to equalize in the long run. The Big Mac index is useful to demonstrate the principles and pitfalls of the PPP theory, according to economists Michael Pakko and Patricia Pollard.
The Big Mac represents a common market basket of goods made up of its ingredients. The composition is generally the same across the world, with a few exceptions like in India. The ingredients such as beef patties, lettuce, cheese, pickles, onions and sesame-seed buns are traded on the international market.
PPP, however, did not really hold in practice. Lebanon, Sweden and Switzerland’s currencies were overvalued against the dollar in July and the rupiah joined the other currencies that were undervalued.
From April 2000 to July 2020, the rupiah remained undervalued relative to the dollar. It occasionally moved toward PPP, such as in late 2000s as shown in the right panel of the following graph.
Price level and income
The price difference of a Big Mac in Indonesia and the US follows a pattern that prices tend to be higher in high-income countries.
Using the World Bank’s classification, the median price of a Big Mac in July was $2.86 in the lower middle-income countries, $3.24 in upper middle-income countries and $3.80 in high-income countries, represented by the horizontal lines inside the boxes in the graph below.
Price differences among the groups are associated with differences in labor cost. In 2000, for example, a typical McDonald’s worker in the US earned $6.50 per hour while his or her Indonesian peer only 63 US cents per hour, according to a 2001 study by economists Orley Ashenfelter and Stepan Jurajda.
It would take less than 40 minutes of work for the American worker to buy a Big Mac. But the Indonesian worker would need to work nearly three hours to get a bite of the sandwich.
The difference in labor cost might partly explain the difference of around 68 cents in Big Mac prices in both countries in 2000.
When comparing countries, the relationship between Big Mac prices and per capita income is generally positive, according to Pakko and Pollard.
After adjusting for gross domestic product (GDP) per person, the price of a Big Mac was expected to stand in July at $2.67 in Indonesia and $5.10 in the US.¹ The GDP-adjusted prices are higher than the actual price for Indonesia but lower than the actual price for the US.
By comparing the adjusted prices, the rupiah is undervalued by around 21.2 percent relative to the dollar.²
Food for thought
To rigorously assess the relationship between Big Mac prices and GDP per person may require a more representative sample of countries and observations.
Other factors like tariff, transportation cost, rent, utility, tax and competition also drive the prices. In some cases, these factors can lead to price differences even within a country.
The Big Mac index may not be able to single-handedly explain whether a currency stands at its “correct” level relative to another currency.
But, as The Economist puts it, the index has made the theory of PPP more digestible.
Despite the index and the concept having limitations, the Big Mac index clearly gave me a food for thought over the past weekend.
Notes
¹ The GDP-adjusted Big Mac prices are obtained from a simple linear regression where the intercept is the mean Big Mac prices in July, namely $2.51. The predictor variables are the 2019 GDP per person in thousand dollars of 37 sample countries with a coefficient of 0.041 and a margin of error ± 0.0098. The t-value is 8.17. However, the adjusted prices are different from the ones calculated by The Economist, which are $2.77 for Indonesia and $5.17 for the US.
² The Economist calculates the valuation of a currency relative to the dollar as measured by GDP-adjusted Big Mac prices using the following equation: p*/p*ᵃᵈʲ × p$/p$ᵃᵈʲ – 1 * 100, where p* is a country’s Big Mac price in dollars, p*ᵃᵈʲ is that country’s GDP-adjusted Big Mac price in dollars, p$ is the Big Mac price in the US and the p$ᵃᵈʲ is the GDP-adjusted Big Mac price in the US.
My code and data are available on this GitHub repo. Download the Big Mac index data from The Economist’s GitHub repo.
