Say a coconut costs $1 in Thailand and triple in France. If coconuts were the only product, we could simply say that the French price level is triple Thailand’s.
But obviously, coconuts aren’t the only product. And comparing price levels gets tricky once we add another product. Suppose the only other product is the peach. Costs $2 in France and double in Thailand.
Thailand has cheaper coconuts. But France has cheaper peaches. So, how do we decide which country is cheaper?
To decide, the economist fixes some basket of goods and compares its cost across the two countries. Ideally, this basket should reflect what the typical consumer buys.
Let’s say that each month, the typical consumer in each country buys 2 coconuts and 2 peaches.
In France, this basket costs 3 + 3 + 2 + 2, or $10. In Thailand, it costs 1 + 1 + 4 + 4, that’s also $10. The basket costs the same in both countries. We thus conclude that the two countries have equal price levels.
But here’s the thing. We conveniently assumed that the typical consumer in each country buys the same stuff. Which is unlikely, given that in France, coconuts are expensive and peaches cheap. While in Thailand, coconuts are cheap and peaches expensive.
“Cheap: Buy more. Expensive: Buy less.” Economists call this brilliant insight the principle of substitution.
Based on this principle, we expect Frenchies to buy fewer coconuts and more peaches. While Thais buy more coconuts and fewer peaches.
So, let’s say instead that the typical French consumer buys 1 coconut and 3 peaches. While the Thai buys 3 coconuts and 1 peach. Call these the French and Thai baskets.
Let’s see how much the French basket costs in each country. In France, it costs 3 + 2 + 2 + 2, or $9. In Thailand, it costs 1 + 4 + 4 + 4, or $13. This basket is cheaper in France than in Thailand. We thus conclude that France is cheaper than Thailand.
Hmm … what if we instead compare the cost of the Thai basket? Shouldn’t make any difference, right? This basket will again be cheaper in France, right? Wrong.
In France, the Thai basket costs 3 + 3 + 3 + 2, or $11. In Thailand, it costs 1 + 1 + 1 + 4, or $7. This basket is cheaper in Thailand than in France. We thus conclude that Thailand is cheaper than France.
But this is the exact opposite conclusion from before! What’s going on!? Why is the French basket cheaper in France and the Thai basket cheaper in Thailand?
Answer: Substitution bias. Here’s how substitution bias works.
In France, peaches are cheap and heavily-consumed. Not so in Thailand. And so by using the French basket for comparison, we incorrectly imagine that the Thai buys fewer coconuts and more peaches, despite living in a country with cheap coconuts and expensive peaches. We incorrectly imagine that the Thai can’t substitute. We thus overstate the Thai price level. This is substitution bias.
Conversely, in Thailand, coconuts are cheap and heavily-consumed. Not so in France. And so by using the Thai basket for comparison, we incorrectly imagine that the Frenchy buys more coconuts and fewer peaches, despite living in a country with expensive coconuts and cheap peaches. We incorrectly imagine that the Frenchy can’t substitute. We thus overstate the French price level. This, again, is substitution bias.
In the previous video, we looked at the problem of comparability, AKA the Big Mac Problem.
In this video, we looked at the problem of substitution bias. By using one country’s basket for comparison, we overstate the other country’s price level.
Like the Big Mac Problem, the problem of substitution bias has no perfect solution. One limited remedy is to consider BOTH countries’ baskets and take some sort of an average. That’s the basic idea behind fancy measures like the superlative Fisher and Törnqvist indices.
In the next video, we’ll look at how the World Bank actually compares price levels across countries and why it often screws up royally.