Question

Please define purchasing power parity (PPP) and the reason why a good or service should cost about the same in one economy as in another. Does it seem like the law of one price in a perfectly competitive market? How do you think PPP is related to the theory of comparative advantage? Thanks.

Answer 1

With the help of PPP, we find out the exchange rate between 2 countries on the basis of 2 goods which are traded among both the countries. We take into account the prices of both the products.

The formula for PPP is, S = P1/P2

Where S = exchange rate of currency 1 to currency 2

P1 = Cost of good X in currency 1

P2 = Cost of good X in currency 2

In many economies, the likeable trade is considered to be the one which is in equilibrium or we can say that the exchange rates are relatively equal, therefore, it is said that the goods and services should cost same in both the economies to attain equilibrium.

This concept is not like the perfectly competitive because the foreign exchange rates are different for different countries, same prices for both the countries for the same good can be beneficial for one country and loss for another. For both the countries to be on the profit side, their needs to be a fair trade where the relative prices of the goods and services are kept equal rather than the actual price of the product.

The concept of comparative advantage looks for the better country which one is more efficient and cost-effective in the production of the good. The PPP looks for the benefit of both the countries.