Purchasing power and the closely related purchasing power parity theory state that products and services should hold the same cost universally in the world upon converting the value to a common currency via exchange rate. This explanation in theory introduces the idea that the ratio of price level and exchange rates between various countries are equal. This correspondingly points that products or services should have the same cost regardless of the country or currency after the exchange rate of the economies is considered.
Purchasing power parity theory surrounds the law of one price. This law states that viable economies will align the price of identical products and services regardless of country. To achieve this, both countries must express prices in a common currency when exchange rates are considered. In essence, a product costing $1,000 in the United States should have the same price of $1,500 in Canada, if the exchange rates are 1.5 USA/CAD. In the event that the prices do not match, the consumer will look to the lesser price country to buy the product in order to save money. This behavior is known as arbitrage
An important thing about the law of one price is that three variations / provisions are probable. These three probabilities incorporate:
- Transport and transaction expensesalong with obstacles from free trade agreements can generate changes to price parity. For example, the cost of tolls for transportation companies or an increase in fuel costs in one country or another can create price differences.
- Competitive markets, which are a requirement of the purchasing power parity theory. A competitive market where we can buy and sell the products at the same price. For example, when Apple, Inc. releases a new version of the iPhone, buyers can purchase and sell the phone for the same price because the demand is high and the market for the product is competitive.
- Limitation to traded products and services of permanent items, which are similar to a house or immovable structure and are not applicable to the purchase price parity theory. For example, something such as steel, which can be traded across two countries, is a movable product, but a haircut is not something that is movable and therefore, is not subject to the price parity theory.