A Theoretical Analysis of Australia's Elevated Cost of Living

Disclaimer: In a departure from the content of our typical blog posts, I figured I'd incorporate one of my other passions aside from IT: Economics. I realize that economic policy, international trade, and the Weak Axiom of Revealed Consumer Preference doesn't light everyone's fire as much as it does mine, but this post is intended to apply what I've learned and read to our experience here in Australia, particularly in regards to international trade and public finance. If you're sock drawer is in urgent need of sorting, I would not at all be offended if you skip this post, as this isn't the most engaging or entertaining content you can find on the blog. Otherwise, please enjoy :-)

Picture courtesy of Macro Business Superblog

In some of our past posts, we haven't been shy in remarking how expensive Australia is relative to the US, particularly for common household goods (food, clothing, beer... the essentials). Most, if not the vast majority, of Aussies are well-aware of the [nominal] cost differential between Australia and the US. Most Australians I know and work with employ the practice of arbitrage, or buying goods abroad and either A.) shipping them to Australia, or B.) traveling abroad and purchasing their goods overseas, thereby maximizing their consumer surplus.  It is well-known here that for tailored suits, one is better off flying to Thailand than to purchasing them within Australia, as the total cost (flight included) can sometimes be less than purchasing an equiavalent product here in Australia (depending on the quality and quantity of suits purchased).

Already Lydia and I have endured the elevated costs of certain goods, that cost less to purchase and ship from the US than to purchase here.  One such example is our recent purchase of climbing shoes- the pair of Scarpa Thunder climbing shoes that I recently purchased at Paddy Pallin cost me AUD$143 (and that was with 20% off), as opposed to the exact same shoes at REI (not on sale) costing US$130 (so roughly AUD$131), which included international shipping.  We ended up opting to purchase the shoes here so we could climb same-day, however under other circumstances, it may be well worth waiting the two-weeks, and just shipping goods from overseas.

As evident in the above example, it is often not enough to simply look at market exchange rates to determine the differing costs of living (which until relatively recently weren't themselves at all useful- the US didn't switch to a floating-rate exchange rate until 1971, and China still persists in using pegged-rates for their Yuan- hence the infrequent squaking objections of US Dept. of Treasury Secretary Timoth Geitner that China is artificially devaluing its currency to improve its terms of trade, to which China typically replies, "We own your ass").  Nominal values are prices we see when we go to the grocery store, which include not only the value of the good, but also fluctuations in currency, particularly in regards to inflation and monetary supply.  Real values, in contrast, factor out currency fluctuations to determine the actual value of a particular good, or it's "real value".  Real values over time measure purchasing power.  It is nominal prices that result in the primary differences of prices between countries, such as the US and Australia, and what exchange rates intend to offset.



Picture courtesy of AES Wealth

 There exists a fundamental economic law, the Law of One Price, that states, excluding transcation costs (best illustrated by the cost of shipping from the US to Australia) and barriers to trade (best illustrated by import tariffs, customs tax, etc), that identical goods will have the same price in different markets, when expressed in real terms (or in the same currency).  From the Law of One Price, the Purchasing Power Parity principal is derived, which states that exchange rates should move to make the price of a basket of goods the same in each country.  Economists use the CPI (Consumer Price Index) to measure intra- and inter-country changes in price, often characterized as the "cost of living." The difficulty with this measure is finding an equivalent "basket of goods" that is of identical quality and components across the world, as different cultures consume different goods of varying quality and price.  Enter the famed "Big Mac Index" which identifies the price of a McDonald's Big Mac - a product that is comprised of identical or near-identical components and requires the same amount of labor to assemble worldwide- and compares this price across the world, taking into account exchange rates.  Effectively, the Big Mac Index measures the accuracy of currency exchange rates.  The exchange rate that leaves a Big Mac costing the same in dollars everywhere is the fair-value yardstick.  So how close is the Australian dollar to it's "fair value?"  Unfortunately, not that close:

Price (USD):	4.07
Price (AUD):	4.56
Implied PPP	1.12
Actual Exchange Rate	0.92
Margin of Error	21.74%

So why is this figure so far off from what economic theory predicts?  The Economist "beefed-up" (their bad pun, not mine - oh the humor of economists...) the Big Mac index to account for different country's GDP per capita, as average prices should be lower in poor countries than in rich ones because labor costs are lower.  After controlling for GDP per capita ($46,860 in the States, $39,764 in Australia [both in USD]), we find that the Aussie dollar is "overvalued" by 12%- closer than our 22% calculation, but still a good ways off.  So why is the adjusted value still off?  A myriad of reasons explains this discrepancy to the PPP theory, but here are a few that seem to be the most obvious:

1. Costs of non-tradeable goods - There is no theoretical reason why non-tradable goods and services such as property costs should be equal in different countries.  As it is, Australia's property costs generally far exceed that of the States.  These elevated property costs are capitalized in the price of goods.
2. Policy climate - Although controlling for GDP per capita partially offsets this in the above example, the minimum wage laws still impact this figure.  Labor is considerably more expensive in Australia, particularly for the segment of workers that would be working in the fast food industry.  The minimum wage in Australia is $AUD15.51, whereas it is $7.25 in the States, which results in higher inflation, ceteris paribus.  Aside from minimum wage, a number of other Australian federal laws impact the price of goods (particularly agricultural).  In the case of bananas, Australia severely restricts their importation out of concerns for biosecurity and the Queensland flooding effectively destroyed this year's crop, the supply of bananas in the market as been severely diminished, thereby significantly increasing the price of bananas.
3. Economies of Scale - Australia has less than 8% of the population of the US (although nearly comparable in land size, though much of it uninhabitable), thus McDonalds in Australia likely can't exploit the benefits of the downward sloping average cost curve as well as McDonalds in the States.  This applies to the general manufacture and production of must goods, as the Australian market as a whole is much smaller than the comparable market in the States.
4. Taxes- Although my preliminary calculations indicate that Australian Income Effective Tax Rates are lower than those in the US (unlike the States, Australia doesn't charge state income tax, just federal), their equivalent consumption tax (10%) is included in the price of all goods.  Although sales tax varies in the States, it's on average lower (7.25%) than the GST here (10%).  Note that the GST is a Value Added Tax (VAT) and not a sales tax as it is levied in the States.  The significance of this is that a VAT is a much more efficient tax than a sales tax, though the difference is indeterminable to the end-consumer.  It may be relevant to note that Australia also heavily taxes alcohol on top of the GST, resulting in combined tax rates that may exceed $32%.  In-line with many of its socialist policies (in the literal sense, not in the "Obama is a socialist!" way), the alcohol taxes are pursuaint to a "sin-tax." 
5. Transactions costs - Although less likely a factor for Big Macs, the transaction costs of moving goods in and around the country are a contributing factor to the higher price of goods.  Australia must import much of its consumer goods.  Many of Australia's top 25 imports are finished goods, which means a lot of cost is incurred in shipping and transporting these goods from overseas to local markets.  In contrast, Australia's top 25 exports include a majority of commodity goods.  The country's heavy reliance on commodity goods also leads to a higher volatility of its currency due to Australia often depending upon foreign capital investment.  As a result global economic pressures, the Aussie dollar is particularly subject to international credit market volatility (hence why the Aussie dollar dropped so much earlier this month in response to the European sovereign debt crisis).

For the above reasons and more, Australia is an expensive place to live, at least comparatively, but probably not as much as the media would lead many to believe.  Despite some of the populist tidings, it is not as simple as comparing prices here to prices abroad, or even just accounting for differing exchange rates.

One persistent theory, to which more than a handful of Australians subscribe (or at least grant some merit), is that the elevated prices are the result of tacit and explicit price collusion among Australian retailers that began with the 2000 Sydney Olympic games and subsequently were kept elevated after the games concluded.  Fundamental economic theory notwithstanding, I guess it makes for good tea conversation.

The fact of the matter is that each and every economy is very different, in terms of political climate, geographic implications, and population considerations.  Despite all of this, it would seem that Australia still is considered one of the best places to live in the world.