Burgernomics: What Big Macs Say About Our World
- Jack Connors
- Nov 30, 2024
- 4 min read
Updated: Jan 28
McDonald's never meant to revolutionize economics, but the Big Mac has done exactly that.
Humanity once wandered blindly through the dark forest of international currencies. Without a way to convert foreign economies into dollars, understanding how our global counterparts live was nearly impossible. Is China’s 123 trillion GDP in yuan larger than our $29 trillion? What kind of lifestyle does someone in India with 500,000 rupees have? Is she driving herself to work or pedaling others in a rickshaw?
What we need is a way to compare the purchasing power of different currencies. Imagine two people buying all the goods and services in their respective economies and comparing receipts. Only then could we uncover the elusive and highly sought-after purchasing power parity (PPP)—the rate at which two currencies buy the same basket of goods.
The Big Mac Index
Rather than try this Herculean feat, The Economist took a more humorous approach by tracking the price of just one item-- the Big Mac. The thinking went, if the Big Mac is the same burger, lettuce, and bun everywhere, its relative prices could approximate parity. Despite it's tongue-in-cheek origins, the Big Mac Index now features in textbooks and launched a sub-field of burgernomics.
Let's see what the price of a Big Mac says about Argentina!
In 2019, the peso-to-dollar exchange rate was 15:1. Today, it’s 550:1—an astronomical 8,000% inflation in just five years! Market rates can’t keep up, leaving the peso technically undervalued, meaning that if you converted your dollars into pesos at the market rate, you’d find yourself a thousand pesos short when trying to buy a Big Mac.
One of the main purposes of the Big Mac Index is to assess whether currencies are over- or undervalued. While market exchange rates reflect the global trade of goods, they fail to capture the cost of non-tradable goods and services—like haircuts, rent, or labor—that cannot be outsourced or traded internationally. iPhones cost the same worldwide due to global arbitrage, but you can’t outsource Sarah’s manager shift next Tuesday or get a haircut in Vietnam while living in New York.
Since the price of a Big Mac includes both labor and rent, it incorporates these non-tradable costs, making it a more accurate measure of the real exchange rate.
The Penn Effect
In 1991, economists Alan Heston and Robert Summers identified a fascinating relationship between currency valuations and income levels, now known as the Penn Effect. They observed that poorer countries tend to have undervalued currencies relative to richer countries. At first, this pattern seemed like a result of outdated bias, but there’s a clear economic explanation for it.
High-income countries often show overvalued currencies because of their productive export sectors. Increased productivity drives higher wages, which in turn raises prices for non-tradable goods and services—like rent or haircuts—within the local economy. Market exchange rates, however, don’t account for these non-tradables, leading to a higher cost of living than what market rates might suggest.
This discrepancy explains why Switzerland has an $8 Big Mac while Indonesia’s costs just $2.46. Switzerland’s higher wages and rents drive up non-tradable costs, inflating the Big Mac’s price. Conversely, Indonesia’s lower labor and rent costs keep their Big Mac far cheaper.
While the Penn Effect offers a strong explanation for the general relationship between income levels and currency valuation, there are notable exceptions. Countries like Qatar, Singapore, Japan, Taiwan, and Hong Kong—despite having some of the highest wages in the world—exhibit lower costs of living than expected.
Qatar stands out due to its highly distinctive political economy. The Qatari government heavily subsidizes utilities and imposes little to no taxes, drastically reducing the cost of living for its citizens. Additionally, intensive labor is largely performed by foreign workers, who are paid relatively low wages compared to local standards. These factors keep prices for non-tradables lower than might be predicted for such a high-income nation.
Japan, Taiwan, and Singapore’s economies are heavily export-driven, which may encourage their central banks to maintain undervalued currencies to stay competitive in global markets. Low-interest-rate policies in Japan and Singapore further contribute to this undervaluation, making the yen and Singapore dollar appear weaker than PPP suggests.
Beyond monetary policy, local factors also play a significant role in keeping costs down. Taiwan’s affordable healthcare system ensures low medical expenses, while in Hong Kong, around 50% of residents live in subsidized housing, significantly reducing living costs. These unique conditions help explain why their currencies seem undervalued relative to the Penn Effect.
International Comparison Project
Alan Heston wasn’t done changing the world. The economist dedicated his life to compiling one of the most exhaustive catalogs of relative prices ever created. Documenting over 1,000 prices across 140+ countries, Heston and his team developed the pinnacle of PPP: the International Comparison Project (ICP).
Not only is the ICP comprehensive, but it’s also remarkably detailed. Heston reportedly spent hours debating the nuances of regional strawberry jams, and it’s said that rugs were weighed and measured without any intent to purchase. Unsurprisingly, business owners dreaded seeing these researchers walk in. Today, the ICP stands as the gold standard for PPP-adjusted cross-border metrics, widely used by the World Bank.
Armed with an accurate measure of PPP, we can finally convert foreign economies into dollars! Below, I graphed income per person using both the Big Mac Index and the Penn World Table (PWT) PPP exchange rates. The PWT, an extension of the ICP, is maintained by UC Davis and the University of Groningen. Although my PWT data only goes up to 2019, it still demonstrates how the PWT provides a more accurate and consistent estimate.
