By the way, most of my discussion below is drawn heavily from the Highlights paper of the Special Chapter.
Why the PPPs?
The demand for internationally comparable estimates of poverty is considerable. Policy analysts, researchers, and international donor agencies often want to compare the incidence of poverty across countries. These international comparisons can be carried out globally, regionally, or even across two countries.
Now, three things are needed to make such international comparisons: (1) nationally representative data on household expenditures for each country; (2) an international poverty line is needed that represents some predetermined threshold standard of living that is constant across the countries where poverty is to be compared; and, (3) a conversion factor needed to express the international poverty lines into local currency values in order to finally compute for the estimates of poverty using the aforementioned data on household expenditures.
Getting the first one is easy (depending on the availability). As I mentioned, I won't dwell on the second one. So for the third one, what is the conversion factor to be used?
Crucially, it will not be market exchange rates, but instead it will be the purchasing power parities (PPPs). PPPs are conversion factors that ensure a common purchasing power over a given set of goods and services. The chapter goes into detail on the differences between the market exchange rate and the PPP, but suffice to say the PPPs capture the prices of all products while market exchange only captures prices of tradeable goods. Obviously, the value of the international poverty line will depend on the value taken by PPPs, which means that the precise value taken by PPPs can make a considerable difference to the estimates of poverty for any given international poverty line. Moreover, . For these reasons, it is crucial to get the value of PPPs right.
Which PPP?
At heart, PPPs are based on comparisons of prices of a selected set of products across countries. There are many types of PPPs, which depend on where the international comparison will be used for: GDP PPP, household consumption PPP, etc. Using household consumption PPP as and example, PPPs are computed in the following way. First, a basket of goods and services relevant for household consumption was identified. Second, the products in the basket were priced through a survey of retail outlets. Third, PPPs were generated at the “basic heading” level – i.e., a grouping of closely related products, for example, different varieties of rice or types of garments. Finally, basic heading PPPs were “aggregated” to generate a final set of PPPs.
Crucially, the process of aggregation involves weighting basic heading PPPs by an appropriate set of expenditure weights, or shares. In my example, the expenditure shares should accurately reflect the relative importance of basic heading groups of products consumed by households.
The general point is that the choice of the basket of goods and services is crucial for purposes of interpretation and use of a given PPP. In practice, PPPs at the GDP level are commonly used for comparing real incomes across countries. If instead the comparison involves standards of living across households, PPPs for household consumption expenditure would be more appropriate than PPPs for GDP.
As noted, PPPs are available for comparisons of GDP and its various subcomponents. Among these, the PPP most naturally suited for poverty comparisons is that pertaining to household final consumption expenditures.
However, as the special chapter clearly emphasizes, consumption PPPs are not ideal for generating comparable estimates of poverty. They may be inappropriate for poverty comparisons if poor households’ consumption patterns are significantly different from those of the general population. Such a difference may be explained by two broad reasons.
First, poor households may consume different types of products from the general population, i.e., the basket of goods and services priced for compiling consumption PPPs may not match up well with the basket of goods and services consumed by the poor. Some of the differences in the products consumed by the poor and by the general population may be quality related. For example, while both the poor and nonpoor may consume rice, the former may consume a lower-quality variety than the latter. Alternatively, some products are consumed by only one group or the other – automobiles, for example.
A further twist can appear if the prices paid by the poor versus the nonpoor differ in some systematic manner. In particular, to the extent that the poor and nonpoor purchase items in different quantities and/or at different types of retail outlets, one can expect the prices paid by the two groups to differ.
For many products, the unit price may well decline as purchase quantities increase. Since the poor are less likely to be able to afford large purchase quantities, they may end up paying more per unit of the product. Conversely, if the poor frequent fresh-produce markets as opposed to modern supermarkets-–where the retail prices may well incorporate the costs of air conditioning, parking space for cars, and other amenities for shoppers – more often than the nonpoor, they may pay less.
Second, even if both groups consume identical products and purchase them in similar quantities and from similar retail outlets, they are likely to spend very different proportions of their total expenditures on these products.
Thus for example, even if the poor and the nonpoor purchase and consume the same variety of rice and buy it in similar quantities and from similar retail outlets, the poor can be expected to spend a larger proportion of their total expenditures on rice than the nonpoor. Since PPPs are ultimately based on aggregating relative prices by expenditure shares, using the expenditure shares of the general population rather than those of the poor may well yield PPPs that are less than ideal for comparisons of poverty across countries.
Expenditure weights are provided for two different population groups in each country. The first is based on national accounts weights, i.e., weights are drawn from the national accounts and refer to the whole population in the country. The second is drawn from household expenditure survey data and is based on the expenditure patterns of individuals in the bottom 30% of the distribution of per capita expenditures.
While the overlap between these individuals and those who are “poor” in terms of a given absolute poverty line is unlikely to be perfect, the bottom 30% should capture the expenditure patterns of the poor better than the expenditure patterns of the entire population for any reasonable poverty line. As expected, the poor – defined here to be the bottom 30% – tend to spend a significantly larger share of their outgoings on food and nonalcoholic beverages. For example, the shares of food and nonalcoholic beverages are 65.6% and 51.1%, respectively, for the poor and for the general population in Bangladesh. More generally, the expenditure weights presented in the figure show systematic and significant differences in the purchase patterns of the general population and of the bottom 30%.
In a nutshell, the practice of using consumption PPPs for international comparisons of poverty implies that the PPPs are derived via a list of products and associated prices that may not be representative of products consumed by the poor and the prices paid by them. Additionally, the consumption PPPs are derived using expenditure weights, or shares from the national accounts, i.e., they reflect the expenditure patterns of the general population and not necessarily the poor.
To what extent do these two factors affect the generation of international poverty lines and associated poverty rates? Well, you'll just have to check the special chapter yourself. I won't go into those details. Suffice it to say, we generated alternative PPPs that make use of a price dataset that is relevant to the poor, as well as expenditure shares that are reflective of the poor. What turns out is that there are differences between the alternative PPPs, and given that our main purpose is to compare international poverty, we recommend the use of PPPs that are calculated using prices paid specifically by the poor, and using expenditure weights that are exactly represented by the poor.