Case Study: Blades, Inc – Assessment of Purchasing Power Parity
Blades Inc, a US based company that manufactures roller blades, is currently importing from and exporting to Thailand. The decision to work with Thailand resulted from the realization that there were little to no foreign or Thai competitors and Thailand’s potential growth as a country was on the rise. As a result Blades entered into an agreement with Entertainment Product, a Thai retailer, for an annual purchase contract lasting 3years. This agreement stated Entertainment Product would buy 180,000 pair of Blades’ top product, Speedos, annually at a fixed baht-denominated price; which would ultimately result in 10% of Blades’ revenue. Additionally, the decision was made to import certain rubber and plastic components from Thailand. Due to the country’s ability to produce these items at a cheaper rate Blades believed they would be able to keep their cost low. However, Blades failed to enter into an agreement on the price of the plastic and rubber components making them susceptible to the varying price changes. These fluctuations were caused by the country’s rise in inflation. As Blades made all purchases of these components in baht the higher the currency the more money spent on these items; raising their cost. With the purchase of these components Blades currently incurs approximately 4% of their cost of goods sold in Thailand alone. In this case Blades CFO, Ben Holt, is concerned about Thailand’s inflation levels. Although Blades has an agreement with Entertainment Products for an annual purchase amount Holt has begun to question whether it was a good idea to agree to a fixed price with no inflation considerations in the contract. Also, he is concerned about the company’s cost of goods sold as Blades did not enter into a fixed price for the imported plastic and rubber components invoiced in baht making them subject to increases in the price due to inflation in their free floating currency. Holt also wonders if the theories of purchase power parity will affect Blades in anyway. 1.
What is the relationship between the exchange rates and relative inflation levels of the two countries? How will this relationship affect Blades’ Thai revenue and costs given that the baht is freely floating? What is the net effect of this relationship on Blades? The relationship between the exchange rates and relative inflation rates can be understood by reviewing the purchasing power parity (PPP) theory. This theory has two forms; absolute and relative. Absolute states that should there be no international barriers on demand which would shift demand to wherever the price is cheapest for consumers. Therefore, based on this theory prices for the same basket of products in two different countries should be equal when measured in a common currency. This theory would even the “playing field”. Relative purchase power parity takes into consideration the imperfect market and how prices are affected due to transportation costs, tariffs, and quotas. As these things are considered; relative PPP believes that products of the same basket could not be the same price when measured in a common currency. However, it does acknowledge that should two countries transportation cost, tariffs, and quotas be the same then the price of products in the same basket should be the same when compared in a common currency. Additionally, one should always be mindful that should one country’s inflation rate increase relative to that of another’s, the demand for country a’s currency will decline as their exports decline because of increased prices. In considering both absolute and relative PPP the theories put forth the idea that a country with a higher level of inflation on their currency should chose to depreciate its value as a way to offset the difference between the two so that the prices when compared in a common currency will be “the same”. The relationship between the...
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