Video games can tell us a lot about someone’s age: My first console was Nintendo’s original, the NES, so if you do the math, I’m starting to get old (womp womp). Video games can also tell us a lot about someone’s character: By looking at their collection, for instance, you can tell if they’re a sports fanatic, a sadist, or just a straight-up nerd.

But what can video games tell us about economics? Apparently a lot.

Let’s focus on the concept of “purchasing power parity” (alliteration, yay!): People probably prefer (there it is again) to just read the CliffsNotes version. Currencies are worth different amounts, the dollar more than the yen, the pound more than the dollar, a bitcoin more than probably anything. But how do we really know what each one is worth relative to the other?

Today’s travelers who exchange currency get their answers from places like banks and kiosks at airports, whom in turn get their cues from market exchange rates, which are in turn set by a mishmash of political and economic forces, ranging from central bank policies to the frenetic actions of currency traders around the world.

There are at least two big problems with these market exchange rates. First, speculation can drive currency values up and down wildly in the short termlike Sonic the Hedgehog bouncing to survive on levels riddled with obstacles. Second, if we use them to make economic comparisons between countries, they can give us only a half-drawn picture.

Purchasing power parity (PPP) is a theory that insists that the exchange rate between two countries’ currencies should be the one that, when you convert one into the other, gives us the same purchasing power in each place (hence the name). PPP is also a practical tool that screams to potential users, “Don’t listen to the clowns using the market exchange rate!” Instead of accepting what that kiosk says at the airport, it tells us to look under the hood of each country’s economy to see what people are actually spending on stuff and then compare the data. Only then will we be to arrive at the “correct” exchange rate.

How exactly do we find this elusive exchange rate? The answer: baskets. Economists love baskets. But these aren’t Easter egg baskets or the type we put on our bikes, they’re a representative set of goods and services that can be found in the economy. Governments measure inflation by looking at changes in prices of the stuff in these baskets.  Similarly, we can get a measure of the exchange rates predicted by PPP by looking at the prices of identical baskets in each country.

What type of stuff do they put in these baskets? Ideally, it would be a wide swath, ranging from eggs to bread to automobiles.  Big institutions like the IMF and the OCED have created big PPP indices that they use to measure gross domestic products and living standards around the world. But economists have devised more playful ways of determining the PPP exchange rate, using everything from hamburgers to lattes to, well, video games.

Economist Joe Cox, in his paper “Purchasing Power Parity and Cultural Convergence: Evidence From the Global Video Games Market,” creates a PPP index using video game consoles. The logic is this: brand-name consoles are identical around the world, so by looking at their price in local currencies, we can get a sense of how much purchasing power each currency really has. With Cox’s so-called “Video Games index”, we can see if the prevailing market exchange rate overvalues or undervalues a given currency compared to the dollar.

Cox based his index on the famous Big Mac index, which is published annually by the magazine The Economist. The Big Mac is essentially a basket of goods: it’s got a sesame-seed bun, meat, cheese, lettuce, secret sauce (let’s face it, probably just mayonnaise and ketchup). Importantly, Big Macs are pretty much the same all over the world. Hence, under PPP theory, the real price of a Big Mac should be the same too, be it Kansas or Kazakhstan.

But the reality is that Big Macs cost different amounts depending upon where you dine. And it’s not alone. In fact, contrary to what PPP theory predicts, most goods and services differ in price country by country, even region by region. What gives?

The problem comes down to the lack of “arbitrage,” the crucial market force that PPP theory rests upon. Here’s a simple example: If there is a video game, let’s say Mega Man II (my favorite NES game as a kid), and it costs $50 dollars in the US and the equivalent of $20 dollars in Japan, market participants will buy them in Japan and sell them in the States for a profit. This process, arbitrage, will continue until the cross-border price differences of Mega Man II games virtually disappear (fulling something known as the Law of One Price). Multiply this process across a whole range of tradable goods over time, PPP theory predicts, and residents of each country will exchange enough money to adjust domestic prices and the exchange rate such that there is purchasing power parity.

But the real world doesn’t work like this. Economists Alan M. Taylor and Mark P. Taylor, in a paper called “The Purchasing Power Parity Debate,” highlight there are huge problems with PPP theory, particularly the fact that transport costs, taxes, tariffs, and other trade barriers prevent the arbitraging necessary to equalize prices across borders for many goods and services. This is why economists believe that market exchange rates are determined only by stuff that is traded between countries, and this “tradable” sector is only a fraction of most countries’ economies. When was last time you flew on a plane to buy a cheaper hamburger in Guatemala?

Big Macs cost different amounts in different places mainly because they contain “non-tradable” components like labor, energy, and real estate to make and serve them. Wages, rents, taxes, and energy prices are different depending upon where you are. Such price differences are harder to arbitrage away because of immigration restrictions and other barriers to trade, both physical and man-made.

Cox makes a case that his Video Games index doesn’t suffer from the same problem as the Big Mac index. “Video game consoles tend to be manufactured to a finished state in a single production facility and then distributed worldwide,” he writes. “Whereas hamburgers require a reasonably significant amount of localized assembly before the good can be consumed.”

Using Microsoft’s Xbox 360, the Sony Playstation 3, and the Nintendo Wii, he looks at each system’s launch price around the world (during 2005 and 2006). Assessing their prices in local currencies and then comparing that to prevailing market exchange rates, Cox concludes that European currencies were overvalued relative to the dollar while the yen was undervalued compared to the dollar.

Knowing the PPP-predicted value of a currency can tell us a lot of important things about a country’s economy. For instance, if the yen is undervalued compared to the dollar, as the Video Games index shows, then that means American goods are more expensive for the Japanese and, inversely, Japanese goods are cheaper for Americans. This is a boon for Japanese exporters, including gaming companies such as Sony and Nintendo. This type of information can be really helpful, especially if you’re a policymaker or investor.

But even the Video Games index suffers from similar problems to the Big Mac index. Cox himself notes that video game consoles are manufactured in East Asia and, hence, lower transport costs might explain why they’re somewhat cheaper in markets there. Moreover, it’s possible that Microsoft, Sony, and Nintendo use their market power to charge customers in different locations higher or lower prices based on their willingness to pay. Further, there are information problems: many consumers and traders won’t know if video game systems are cheaper in different geographies, meaning there will be missed arbitrage opportunities. Market imperfections like these work against PPP exchange rates manifesting themselves in reality.

Reminiscent of a prolonged match in the classic game Street Fighter II, the fight between economists over whether PPP actually holds has proven difficult to end. Many economists doubt the empirical validity of PPP theory. Research from Mark and Alan Taylor suggests that while it certainly does not hold over the short run, exchange rates seem to move toward their PPP-predicted level over the long run. But there has yet to be a knockout punch.

Nonetheless, whether PPP theory actually describes reality or not, PPP indices like the one based on video game consoles help us think through the complex dynamics behind exchange rates. It reminds us, amongst other things, that the official exchange rate can misrepresent the living standards of a country’s citizens. Many have higher or lower purchasing power than that kiosk at the airport might lead you to believe. And if you care about that sort of thing, this seems to be a game worth playing.

Game over. Please insert some currency to read again (not really).

 

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Resources

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Journal of Cultural Economics, Vol. 32, No. 3 (2008), pp. 201-214
Springer
The Journal of Economic Perspectives, Vol. 18, No. 4 (Autumn, 2004)
pp. 135-158
American Economic Association