Full text of Inside the Vault : Spring 1996

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2/20/2020

For Here or To Go?

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For Here or To Go?
The Big Mac Takes a Bite out of International Trade Theory
Two all-beef patties, special sauce, lettuce, cheese, pickles, onions, on a sesame seed bun ...
Federal Reserve Bank of St. Louis Research Economists Michael R. Pakko and Patricia S. Pollard have
made hamburger out of international trade theory in their examination of Purchasing Power Parity (PPP)
using McDonald's Big Mac as their main entree. The theory states that prices of identical goods in different
countries should be equal after adjusting for the rate of exchange between currencies. PPP has as its
foundation the law of one price which states that the price of any particular good that is traded on world
markets will be the same in every country engaged in trade. For instance, consider the price of sesame seeds
—one of the basic ingredients of the Big Mac—in Britain and the United States. If sesame seeds are cheaper
in the United States than they are in Britain, astute commodity traders will simply buy U.S. sesame seeds
rather than British and sell the U.S. sesame seeds to McDonald's in Great Britain. However, sooner or later
the increased demand for U.S. sesame seeds would drive up their price, and the decreased demand for
British sesame seeds would lower the British price. Obviously over time the law of one price would prevail in
international markets.
Sold in more than 80 countries worldwide, the Big Mac is a standardized bundle of goods. Most of the
ingredients that go into a Big Mac are individually traded on international markets so we might expect that the
law of one price would hold, at least approximately.

Does PPP pass the Big Mac test?
If the PPP passes the Big Mac test, the prices of these hearty sandwiches should be relatively equal after
accounting for exchange rate differences. Let's examine the menu. In 1994 it cost $2.30 to buy a Big Mac in
the United States, $3.77 to buy a Big Mac in Japan, and $1.66 to buy a Big Mac in Hungary. Thus a Big Mac
devotee could buy nearly 1 2/3 of the sandwiches in the United States for everyone one he could purchase in
Japan. But he'd be in a pickle in the United States since he could only buy less than 3/4 of a Big Mac for
every one he could enjoy in Hungary.
However, one wouldn't expect Japanese and U.S. consumers to import Big Macs from Hungary to take
advantage of the lower prices—a Big Mac sandwich shipped halfway across the globe would probably not be
very tasty.
If the Big Mac is no more than the sum of its ingredients, then trade should equalize the price of a Big Mac
across borders; or at the least, differences between prices should narrow over time. Instead, the dollar price
of a Big Mac in the three countries diverged by even more in 1995 than in 1994. In 1995 it cost $1.58 to buy a
Big Mac in Hungary, $2.32 to buy a Big Mac in the United States, and a beefy $4.65 to buy a Big Mac in
Japan.
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How do Pakko and Pollard explain these deviations from the PPP? Their explanations include the existence
of barriers to trade, the inclusion of non-traded elements in the cost of a Big Mac and imperfect competition.

Barriers to Trade
One simple reason why PPP fails to hold is that it is costly to ship goods across countries. The cost of
shipping the sesame seeds needed for the Big Mac buns may be minimal, but shipping perishable ingredients
such as lettuce and beef is more costly. Transportation costs, therefore, may drive a wedge between the
prices of the same good in different markets.
A more important factor than the presence of natural barriers to trade is the existence of tariffs and other legal
restrictions on trade. Nearly every country restricts the importation of agricultural goods through the use of
tariffs and quotas in order to protect its domestic farm sector. Tariffs, which represent a tax on imported
goods, and quotas, which limit the amount of a good that can be imported, both raise the price of agricultural
imports.

Non-traded Goods
The price of a Big Mac in any country reflects more than the price of its ingredients. To sell its products,
McDonald's has to buy or lease space for a restaurant and purchase utilities to heat, cook and light the
restaurant, as well as to run everything from the grills to the cash registers. Real estate and utilities are not
traded internationally. To the extent that rent and utilities determine the cost of a Big Mac, deviations from
PPP may simply reflect these cost differences across countries.
The price of a Big Mac also reflects a service component—that is, the cost of preparing the Big Mac and
serving the customer. These aspects require the use of workers, who in economic terminology are also nontraded goods. McDonald's workers, like all workers, are restricted in their ability to move across borders to
take advantage of wage differentials.

Imperfect Competition
Under the condition of imperfect competition, traded goods prices may not be equal across countries. Though
it may have close rivals in some markets, the Big Mac itself is produced by only one company; therefore, we
might expect to find market conditions of imperfect competition. In some markets, most notably the United
States, the Big Mac has close substitutes; in others, the Big Mac has few substitutes. Perhaps this is because
a Big Mac is more than the sum of its ingredients. In Russia, for example, the price of a meal at McDonald's is
expensive relative to other restaurants. However, the quality of the food is considered far superior to that
offered in most other restaurants frequented by the average Russian. In addition, the food itself is only part of
the attraction. People choose to frequent McDonald's for more than the burgers, such as the courteous,
efficient service or cleanliness of the restaurant.

The Last Bite
Since many of its basic ingredients are tradable goods, we might conclude that prices of Big Macs would be
subject to the theory of Purchasing Power Parity (PPP) and the law of one price. However, its other
characteristics make the Big Mac a good example of why the theory of PPP generally fails to hold except
under special circumstances.

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A New Jingle?
To aficionados of classic television commercials, the ingredients of a Big Mac sandwich are indelibly etched
into memory in the form of a jingle. In terms of the United Nations' Standard International Trade
Classifications (SITC), the jingle might sound a little different:

Ingredient

SITC Code

All-beef patties

01122

Meat of bovine animals, boneless,
frozen

Special sauce

09849

Sauces and preparations, not
elsewhere specified (NES), mixed
condiments, and seasonings

Lettuce

05454

Lettuce and chicory, fresh or
chilled

Cheese

02420

Processed cheese, not grated or
powdered

Pickles

05456

Cucumbers and gherkins, fresh or
chilled

Onion

05451

Onions and shallots, fresh or
chilled

Sesame-seed bun

04849

Baker's wares, NES

22250

Sesame (sesamum) seeds

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SITC Description

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