Purchasing Power Parity Method

Suppose you're an American tourist visiting Korea. You spot a dress costing 10,000 won. This can sound incredulous at first, as you can be used to hearing prices with lesser zeros in your own currency.

However, taking into account that a dollar could buy approximately 1,300 won, then you are looking at a bargain in actuality. Unfortunately, for a Korean who may just be earning a monthly income of 15,000 won, that bag is considered a luxury. To even out the power of the dollar or any other strong monetary unit over certain currencies, economists take into account each country's cost of living and not the direct conversion, when pricing goods. This method is called the purchasing power parity.

The purchasing power parity method

Aside from pricing goods succinctly, the Purchasing Power Parity or PPP is also an indicator used when determining the currency exchange rate. However, for products that come from other countries, pricing it based on the actual exchange rates may prove to be unreliable and unfair especially for countries who have the weaker currency. To offset this problem, the PPP method considers a country's GDP or gross domestic product when pricing a commodity and the exchange rate for the local currency.

When pricing a commodity or a product, the PPP stands by one tenet - “the law of one price.” This states that a commodity or a product should be charged under the same or similar price in two markets, given that no other fees, taxes, and even transportation costs were involved.