Question

Explain why price levels are lower in poorer countries?

Will you discuss why the empirical support for PPP and the law of one price is weak in recent data?

Answer 1

Solution:-

The price levels are lower in poorer countries by these reasons:-
1. Because of lower productivity.
In rich countries, labor productivity in tradable sector is higher and people earn higher wages. This tends to push up wages in services sectors, as higher wage in tradable sector drives up demand for more and better services.  In poor countries, labor productivity in tradable sector is lower and people earn lower wages, although tradable sector also has the similar push-up effect on services sector, but the push is not as big as in developed countries.  So as a whole, price level in developing countries is lower than that in developed countries.

2.Because of lower capital-labor ratio
Developed countries are relatively capital intensive, and developing countries are relatively labor intensive. This is another way of saying developed countries have higher capital-labor ratio or capital intensity than developing countries.  With higher capital-labor ratio, this would imply higher labor productivity in developed countries, which leads to higher wages. The lower wage in developing countries will imply lower price levels in non-tradable sectors (lower cost), and leads to lower price levels as a whole in developing countries (note the prices in tradable 16 sectors tend to be quite similar).

(b) this concept is weak because, If PPP holds
then the price of an internationally traded good should be the same anywhere in the world
once that price is expressed in a common currency since people could make a riskless
profit by shipping the goods from locations where the price is low to locations where the price is high.

Hope it helps you.