Law of One Price – the _

[2726] The Big Mac Index is not about cheap burgers, NST

The Big Mac Index is one of those funky things in the world of economics that a lot of people think they know about it, but they actually do not. The New Straits Times on Saturday featured the Index in a big way to show that Malaysia has the third cheapest Big Mac in the world.^[1] Unfortunately for the newspaper, in doing so, it proves to the world that they do not know what the Index is about. And they did that in a grand style, by putting it on the front page.

The Big Mac Index by the Economist does have a list of Big Mac prices from a number of countries. But the point of the list is not to aid burger hunters searching for the cheapest Big Mac in the world. Rather, the point is to give the readers a feel of how overvalued or undervalued a currency is, typically against the US dollar (these days, the Economist has introduced multiple other reference currencies).

The Index is designed to demonstrate a theory called the purchasing power parity. The PPP, although not exactly the Law of One Price, pretty much operates on the same logic the Law of One Price operates. If the PPP holds in the world of Big Macs, then all Big Macs would cost the same. When there is divergence in prices between two… national… burgers, then it suggests that either one or the other is overvalued or undervalued.

So, if Malaysia does have the third cheapest Big Mac in the Index, what the Index is telling you is that the ringgit is the third most undervalued currency in the Index (against the US dollar, the reference currency).

The NST seized on the word cheapest to give an idea that it is cheap to live in Malaysia. “Malaysia has been ranked one of the cheapest places in the world to purchase a Big Mac,” goes the very, very bad article. In a companion article that is equally awful:

Independent economic macro-analyst Prof Dr Hoo Ke Ping said while it was true that some might find prices of food items to have risen somewhat, Malaysians should be thankful that they can still enjoy relatively cheap meals compared with other countries.

He said the Big Mac index was proof that essential items in the country were still relatively cheaper than other countries.

“Although some prices of food items, petrol and electricity have gone up, our prices are still cheap.”

Hoo said it was a misconception that prices of essential items had gone up, adding the speculation was sensationalised, over-hyped and not fully defined. [Big Mac index an accurate indicator. New Straits Times. February 15 2014]

You get the idea what the NST is trying to say. It is really a propaganda hack and not actual news. NST itself has no understanding of the Index, much less of the PPP. It does not care about the economic rationale behind the Index. NST is only forcing the economics to fit into the paper’s preferred narrative, which is horribly flawed.

As for the professor, I present to you, a big chart of the monthly YoY changes of all of the major components of the consumer price index throughout 2013:

Please do not tell me that the prices of essential goods have not gone up (no, I am not referring to the alcohol and tobacco component although I do understand, those are essential items for some people. For the majority, look at the rising food and more jarringly, transport inflation).

Now, it may or it may not be cheap to live in Malaysia but using the Index to demonstrate that is just not the way.

To make that argument on living cost, you need to make at least one more step and that is to find the income of the median Malaysian. From there, you can calculate just how many burgers that Malaysian can buy with his or her salary. Compare that to the same metric in another country and only then you can say whether it is cheap to live in Malaysia.

The way the reporter writes it, it is cheap to live in Malaysia if you earn in stronger currencies like the US dollar, which is true and you can definitely know that from the Index.

But most Malaysians do not earn in dollar. That fact really makes the NST’s argument irrelevant.

Finally:

Accountant Muhammad Aiman Sofian said lower salary levels in Malaysia meant that the ratio of expenses to income was smaller compared with other countries. [Big Mac index an accurate indicator. New Straits Times. February 15 2014]

You have got to be kidding me… that just goes against empirical evidences from all around the world.

Mohd Hafiz Noor Shams. Some rights reserved

^[1] — KUALA LUMPUR: MALAYSIA has been ranked one of the cheapest places in the world to purchase a Big Mac, according to The Economist.

The British news magazine’s annual “Big Mac” Index, which gauges if global currencies are at their correct level, has ranked Malaysia third behind India and South Africa as the cheapest place in the world to purchase the McDonald’s signature burger.

“The price paid for a Big Mac in Malaysia is RM7.40, which is equivalent to US$2.23 when converted using the global exchange rates.

“This amount is lower when compared with the actual price of a Big Mac that is sold in the United States for US$4.62, indicating a 50 per cent difference.

“In other words, the Big Mac sold in Malaysia is half the price of the same burger sold in the US,” the magazine revealed.[Malaysia is 3rd cheapest place to buy a Big Mac. New Straits Times. February 15 2014]

[2168] Of no to the policy of One Price

Prices of the same tradable items in different places tend to converge in a perfectly efficient market. Theoretically, motivated by profits, individuals and entities act as arbitrageurs. They will continue to arbitrage until there are no more profits to be made. That is when prices equalized and that is the essence of the law of one price.

Prices may not actually converge to one price due to several factors however because market can be inefficient. Limited access to information crucial for the purpose of arbitrage may prevent convergence. Transportation cost as well as government intervention in terms of taxation and subsidization are two of several other important frictions. Instead of prices equalizing, a price spread exists to reflect those frictions even as market participants exhaust arbitrage opportunity.

This is essentially the reason why there is noticeable price differential for the same tradable goods sold in eastern and western part of Malaysia. With the South China Sea separating Malaysia into two parts, it is only natural for prices to differ between the two regions. Even under the price and supply control mechanism that exists in Malaysia, a kilogram of sugar for example, is sold 10 sen cheaper in Peninsular Malaysia than in Sabah and Sarawak. Transportation cost is a considerable barrier preventing actual convergence.

This is a source of discontent for some. Member of Parliament for Kalabakan, Abdul Ghapur Salleh of UMNO said in November 2009 said, “We’re talking about 1Malaysia, but we don’t even have one price” while alleging that the price differential is more insidious in nature — discrimination against Sabah and Sarawak — rather than simple economic friction.

It is unclear how exactly he wants effort at standardization to proceed but the approach by the federal government is clear. In the same month, Minister Koh Tsu Koon supported the idea of standardized prices across Malaysia and proposed that transportation cost be shared by all; in other words, introduce subsidy. Nearly a year earlier, Domestic Trade and Consumer Affairs Ministry wanted to do the same: subsidize transportation cost. In Sarawak itself, perhaps a harbinger preceding a possibly wider similar nationwide policy, the same ministry plans to subsidize transportation cost with the intention of standardizing prices of essential items sold in urban and rural areas under its “One Sarawak, One Price” campaign.

They are turning the law of one price on its head. Rather than letting market forces find its equilibrium where a particular price fits a particular landscape through a narrow band, the government intends to impose unnatural standardized prices for all situations everywhere to force convergence. The government intends to introduce more inefficiency to standardize prices.

The discontent over price differential is overrated. Two economists — Lee Chin and Muzafar Shah Habibullah of Universiti Putra Malaysia — published a paper in 2008 showing that prices of tradable goods between Peninsular Malaysia, Sabah and Sarawak are converging. Furthermore, the recent liberalization of cabotage policy — a protectionist policy that contributed to persistent price differential between eastern and western part of Malaysia — will likely further strengthen the natural convergence trend.

Convergence aside, to iterate the idea of how the difference is natural, the price differential has nothing to do with discrimination between the two parts of Malaysia. It is a reality that there is a large body of water separating the two parts of Malaysia. It is likely that if the transportation cost is brought down either through liberalization or improvement in technology, prices are likely to equalize, all else being equal.

The price differential due to transportation cost or distance has nothing to do with the idea of unity as much as it has something to do with the idea of discrimination. In the United States for instance, gas prices in Michigan and in California are very different. Even in the same state, prices of gas in one town can be different from another town a mile away. That does not make the person who pays higher price as less American than the other person who pays lower price for gas.

This idea can be expanded to Peninsular Malaysia. The government should not standardize prices within Malaysia. This is not to say just prices between Peninsular Malaysia, Sabah and Sarawak, but within those regions as well. What a free Malaysia needs is not a Price Control Act, but a Competition Act or antitrust law to fight collusion among businesses in order to encourage competition — the most effective method at encouraging convergence and low prices — without suffocating entrepreneurial spirit.

On top of that, maybe, just maybe, the move of having manufacturers based in Sabah or Sarawak is a cheaper and a more profitable option compared to the option of transporting goods from Peninsular Malaysia or from abroad even after accounting for various other effects like clusterization.

If the subsidization program goes through, it removes that incentive and hence, the possibility of developing industries in eastern Malaysia. If a business owner could transport his or her goods free from western to eastern Malaysia, why would the business owner locate his or her factory in eastern Malaysia? There are better ports, roads, financial services — practically everything that matters in business — in Peninsular Malaysia than in Sabah and Sarawak. The subsidization program would continue to industrialize the Peninsula while leaving Sabah and Sarawak farther behind in terms of development.

Besides, the Prime Minister recently said that private initiates and market forces have to be given freer rein while subsidies be phased out. The standardization of prices across Malaysia through subsidization of transportation cost by the government clearly contradicts that. Is this a proof that there is no coordination within the government? Or does words mean nothing to the government?

For the answer to be no on both accounts, the policy of “One Price” must be rejected.

Mohd Hafiz Noor Shams. Some rights reserved

A version of this article was first published in The Malaysian Insider on February 22 2010.