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It’s more of an art than a science

  • Published at 12:24 am April 16th, 2017
It’s more of an art than a science
One of the things we’d like to be able to do in economics is compare. Compare growth rates, compare inflation, compare standards of living. For the entire enterprise is based on the idea that we want people to have the best lives possible. This is the aim itself, we want people to be as rich as they can be. That, of course, leads us to the central economic problem. There are many things that people want and desire and yet we’ve only got scarce resources with which to meet these. We thus need some system, any system, to work out which of those things we’ve not got much of should be used to do what so as to produce the greatest benefit -- we use the technical word utility here -- to as many people as possible. But comparing can cause problems -- for example, how can we compare the standard of living if different things cost different amounts in different places? Just using the usual foreign exchange rates won’t tell us about that. We’ve also a further complication, that some things will cost the same amount everywhere, other things won’t. This is something that David Ricardo pointed out all the way back in 1819, his law of one price. Something which is traded around the world will be the same price around the world plus any transport or tax costs. If it wasn’t the same price then people would buy it where it is cheap and sell it where it is expensive -- what we call arbitrage and the thing which is the basis of most trade.
In the modern day, consider Apple’s iPhone. Adjusting for local taxes that is pretty much the same price everywhere. Things that are not traded, the usual example being a haircut, varies in price hugely around the world. Dhaka and London are both capital cities but that rim costs a great deal less in Bangladesh
In the modern day, consider Apple’s iPhone. Adjusting for local taxes that is pretty much the same price everywhere. Things that are not traded, the usual example being a haircut, varies in price hugely around the world. Dhaka and London are both capital cities but that rim costs a great deal less in Bangladesh. In order to be able to compare standards of living, we therefore invent something called purchasing power parity. This works backwards, which is odd, but it’s still useful. What we say is, well, what would the foreign exchange rate be in order to make the standard of living for a certain amount of money the same? We call this the PPP exchange rate instead of the market one. And they do vary considerably. Of course, such PPP calculations are more of an art than a science -- but close enough the Tk to $ exchange rate is 10 and the PPP one is around 30. Rents are cheaper in Dhaka, food is cheaper -- and yes, while food is traded, most food consumed is locally produced. What this means when we run it forward is that if, say, that minimum wage in the garment factories of Tk5,500 were properly compared to American costs of living then it would be about $150, not the $50 that the market exchange rate has it as (yes, I know that’s not quite the right rate, this is just to keep it simple). One use of this is that when we measure absolute poverty, using the World Bank standard, we say $1.90 a day. But that’s at the PPP exchange rate, not the market one and we’re always comparing to American prices. So, for Bangladesh, that’s not Tk20 a day but more like Tk7 -- to get from $ to Tk we divide by the PPP rate, not multiply. And yes, we do really think that’s horrible poverty. Another use is in the campaign by Clean Clothes, the people insisting that that minimum wage in the garment factories must be much higher. They say that in order to live the sort of life they think people ought to be able to live that a garment worker in Asia should get around $1,000 a month. This is obviously a nice target for everyone but it’s ridiculous in reality. Still, they do get it right that we shouldn’t use the market exchange rate to translate this into local wages, instead we should use the PPP rate. This thus becomes, close enough, the Tk30,000 they insist should be the minimum wage, not some absurdity like Tk100,000. They have, correctly, divided by the PPP rate to get to the local wage rate because that’s what gives us the same standard of living across countries. In technical detail they’re correct therefore -- even if in reality they’re mad. For they’re now insisting that entry level wages in a factory should be higher than the average income for the entire country. We would all very much like for wages to be higher because that would mean that people would be living better lives. But the idea that a minimum wage should be twice what a high school teacher gets in the private sector is going to cause more than a little disruption to the economy, isn’t it? Might denude the education sector and thus lower long term growth and richness perhaps? The essential mistake that Clean Clothes are making here is to believe that wages are or should be set by how much money the customers have. That’s simply wrong -- they’re set by the average wage in the country doing the production. Average wages in Bangladesh are low, therefore wages in the garment factories are low. Simply because there’s many more tens of millions available at low wages. And what will raise wages in the factories is that wages rise generally, we can’t wall off one sector as the campaign tries to. This purchasing power parity idea is very useful as long as we properly understand what it is that we’re doing. Things cost different amounts in different places. Traded goods trend at least to the same price, services and less traded things not so much. But adjusting that market exchange rate to account for this then we can, roughly enough it must be said, compare actual standards of living. That still doesn’t mean though that we can have a minimum wage which is higher than the average output per person in the country, which is what Clean Clothes is arguing for. In fact, when we use PPP properly, they want the minimum wage to be three times GDP per capita, an absurdity even if they are using PPP itself the correct way.   Tim Worstall is a Senior Fellow at the Adam Smith Institute in London.