Which of the following doesn’t explain the deviations from the PPP?
a. Trade barriers and non-tradable products.
b. Imperfect competition and productivity differentials.
c. Differences in measures of average prices for baskets of goods and services, and in composition of baskets of goods consumed in different countries. d. Zero productivity differential.
The correct answer and explanation is:
Correct answer: d. Zero productivity differential.
Explanation (Approx. 300 words):
Purchasing Power Parity (PPP) is an economic theory that suggests that in the absence of transaction costs and other frictions, identical goods should have the same price when expressed in a common currency. Deviations from PPP occur frequently in the real world, and economists have identified several reasons for this.
Option a: Trade barriers and non-tradable products
This explains PPP deviation. Trade barriers such as tariffs and quotas can prevent the free movement of goods, leading to price differences. Also, some goods and services (like real estate or local services) are non-tradable and cannot be arbitraged internationally, causing price disparities.
Option b: Imperfect competition and productivity differentials
This also explains PPP deviation. In reality, markets are often not perfectly competitive. Companies might have pricing power due to brand value, location, or product differentiation. Also, differences in productivity across countries, especially in the tradable vs. non-tradable sectors, can affect relative prices and thus violate PPP.
Option c: Differences in measures of average prices and consumption baskets
This is another valid reason. Each country calculates its price index using a unique basket of goods and services based on local consumption habits. These differences in basket composition and measurement techniques lead to variations in price levels across countries, affecting PPP comparisons.
Option d: Zero productivity differential
This does not explain a deviation from PPP. In fact, if there is zero productivity differential, it means both countries have the same level of productivity, removing a potential source of price distortion. Therefore, this option fails to explain a deviation and is the correct choice for the question.
So, the factor that doesn’t explain deviations from PPP is zero productivity differential.