Any web sites, answers, comments, etc. are needed to help answer the
following question:

The Big Mac Price Index computed by the Economist has consistently
found the U.S. dollar to be undervalued against some other major
currencies, which seems to call for a rejection of the purchasing
power parity theory.  Explain why the index may not be a valid test of
the theory.

Hello.

I've surveyed a number of sources that discuss the weaknesses of the
Big Mac Index as a test of purchasing power parity  (PPP) theory.  The
main points made are that the Big Mac is not an internationally
tradable commodity (i.e., countries with low-cost Big Macs can't
export the burgers to high-cost countries). PPP theory requires that
the goods in  the comparison should be  tradable so that high-cost
countries can import the goods from low-cost countries thus forcing
currency values back to purchasing power parity. Other weaknesses in
the Big Mac Index include distortions in Big Mac prices caused by
local sales taxes, local competition, rents, and import tariffs on key
Big Mac ingredients such as beef.

Here are some excerpts from various articles and web pages that
discuss the problems with the Big Mac Index:

"Purchasing power parity is best thought of as a long run theory of
exchange rate determination. The Big Mac is not a tradable good and
its price does vary between locations in any given country. This means
that the Big Mac Index is likely to prove an imperfect indicator of
future exchange rate movements."
Source: Econedlink.org: Big Mac Index
http://www.econedlink.org/lessons/index.cfm?lesson=EM156

"Objections based on its flaws include variable tariffs, trade
barriers and local subsidies on beef, differing rates of goods and
services, sales or value-added taxes and substantial differences in
property values and other fixed costs - and, more recently, variable
marketing problems due to product safety perceptions in several
countries should be added - but for all of that, it demonstrates
robust usefulness as a price indicator."
Dennis McDermott: Purchasing Power Parity
http://www.mcdint.com/ppp.html

"This whole practice is based on the economic theory of
purchasing-power parity, which roughly states that the dollar should
buy the same amount of goods in all countries. Over the long run,
supporters of theory argue, the exchange rate between two currencies
should converge to equalize the price of an identical basket goods in
each country.
And, notes the magazine, the index is pretty good, although things
like trade barriers on beef imports, local taxes and local costs, such
as rent, can distort the index."
Source: Cincypost.com: "Economists chew on Big Mac index"
http://www.cincypost.com/business/1998/watch042898.html

"To be sure, the Big Mac Index is one of the least academically
satisfactory indices of the value of the US Dollar ('[the index] is an
imperfect basket',
[the Big Mac] is not internationally traded', 'local taxes distort the
price', etc.). Purchasing Power Parity theory requires that the goods
in the basket, which forms the basis of comparison, should be
internationally tradable - so that consumers in high cost countries
can import the goods from low cost countries and force currency values
back to purchasing power parity. Yet the Big Mac Index has 'gut feel'
validity!"
Source: Martin Murenbeeld, "Currency and Interest Rate Comments",
Financial Monitor, hosted by murenbeeld.com
http://www.murenbeeld.com/pdfFiles/US$CA.pdf

"The Big Mac PPP is a gross (but powerful) simplification of this
theory and would work just as well as the full basket of goods and
services if markets were prefectly free - if there were no government
interventions to 'distort' significant parts of the price of the Big
Mac between countries, or restrictions and interventions which distort
and prevent trade in other goods and services, or restrictions and
interventions on capital movements between countries.

The fact that Big Macs are not tradable doesn't matter - exchange
rates should adjust on the basis of tradable goods, which will feed
through to non-traded goods."
Source: David Hervey, "Big MacCurrencies and Purchasing Power
Parities," The University of Newcastle upon Tyne
http://www.staff.ncl.ac.uk/david.harvey/AEF116/2.5/PPP.html

"Of course - see Economist - the Big Mac index is far from perfect. In
particular, we know that (especially in the EU and Japan) the price of
beef is not a free trade price - Both the EU and Japan protect their
domestic beef markets by charging very substantial import taxes
(tariffs or levies) on beef, thus increasing their local prices,
though the price of raw beef is a relatively small part of the price
of a Big Mac. However, there are a lot of other 'distortions' - local
sales taxes, local competition, rents for property etc. 'But, despite
these flaws, the Big Mac index produces PPP estimates close to those
derived by more sophisticated methods" (which try to take account of
these factors).'"
Source: David Hervey, "Big MacCurrencies and Purchasing Power
Parities," The University of Newcastle upon Tyne
http://www.staff.ncl.ac.uk/david.harvey/AEF116/2.5/PPP.html

"The Big Mac Index
LOP and PPP may not hold because of:
Transactions costs
Tariffs
Taxes
Non-identical goods and services
Doesn't apply to non-tradable goods"
Source: Moore School of Business, University of South Caroline,
JBreur, "Money, Inflation, and Exchange Rates in the Long Run"
http://dmsweb.moore.sc.edu/jbreuer/econ719Ts02/lec6.doc

"The Big Mac Index: While a tongue-in-cheek measure, the Big Mac is
interesting as both a non-traded good and a pure commodity in that
there are no quality differences from nation to nation. The factors
that go into the production of the Big Mac consist of agricultural
products, retail rent, utilities, and labor costs. These factors are
all non-tradable. 'Extensive studies' have shown that the price of a
McDonald's Big Mac can serve as a proxy for a country's market basket
of good and thus a cost-of-living index."
Auburn University: "Considerations:  Should You Hedge and What is the
True Cost of Hedging?"
http://www.auburn.edu/~pughwi1/ppp.html


While the Economist's Big Mac Index receives more popular attention
than other comparable efforts, there exist better cross-country price
comparisons. For example, the OECD and the United Nations are involved
in the International Price Comparison Programme (ICP), which surveys a
wider range of prices and therefore produces more rigorous estimates
of the exchange rates that would eliminate price differences between
their member nations."
Source: Anne-Marie Brook and David Hargreaves, "PPP-Based Analysis of
New Zealand's Equilibrium Exchange Rate," hosted by the Reserve Bank
of New Zealand
http://www.rbnz.govt.nz/research/discusspapers/dp01_1.pdf

"Big Mac Index: a great example (Ag Related !!!).
Criticisms: no local taxes, poverty values, and tariffs affecting the
price are accounted for."
Source: University of Wisconsin: Agriculture and Applied Economics:
"The International Agricultural Economy" lecture notes
http://www.aae.wisc.edu/aae319/319week7/tsld005.htm

search strategy: "big mac index", parity, tariffs, taxes, tradable

I hope this helps.