Law of One Price

Definition

The Law of One Price states that in efficient markets, identical goods should sell for the same price when expressed in a common currency, assuming no transportation costs and no differential taxes applied in different markets. This principle underpins various economic theories and helps explain the behavior of prices in international financial markets.

5 Must Know Facts For Your Next Test

1. The Law of One Price assumes that there are no transportation costs, tariffs, or other barriers affecting price differences across markets.
2. This law is foundational to understanding how exchange rates are determined, as it links the price of goods to currency values.
3. In practice, real-world factors like shipping costs, trade barriers, and local taxes can cause deviations from the Law of One Price.
4. The Law of One Price is a key assumption in purchasing power parity calculations, which are often used to compare economic productivity and standards of living between countries.
5. Market inefficiencies can lead to temporary violations of the Law of One Price, but arbitrage opportunities usually correct these discrepancies over time.

Review Questions

• How does the Law of One Price relate to market efficiency and its implications for international trade?
  • The Law of One Price is closely linked to market efficiency because it assumes that all available information is reflected in prices. In an efficient market, identical goods should have the same price across different locations when accounting for exchange rates. This concept supports international trade by ensuring that prices adjust to reflect currency values and eliminate arbitrage opportunities, promoting a more balanced trading environment.
• Discuss how transportation costs and tariffs can affect the applicability of the Law of One Price in real-world scenarios.
  • In real-world scenarios, transportation costs and tariffs can create significant obstacles to the Law of One Price holding true. If transporting goods incurs high costs or if tariffs are imposed on imports, prices may differ between markets despite identical products. These factors lead to a situation where the law may not apply perfectly, as sellers may set different prices based on additional expenses that affect their profit margins.
• Evaluate the impact of arbitrage on maintaining the validity of the Law of One Price across different markets.
  • Arbitrage plays a crucial role in maintaining the validity of the Law of One Price by exploiting price differences in separate markets. When traders identify opportunities where identical goods are priced differently due to market inefficiencies, they can buy low in one market and sell high in another. This activity helps equalize prices across markets, reinforcing the law's principles. However, if arbitrage opportunities persist for extended periods, it may indicate underlying market inefficiencies or barriers preventing price alignment.

Related terms

Purchasing Power Parity: A theory that suggests that exchange rates should adjust so that identical goods have the same price across different countries when expressed in a common currency.

Arbitrage: The practice of taking advantage of price differences between markets, which helps ensure that the Law of One Price holds by equalizing prices through buying low in one market and selling high in another.

Market Efficiency: The degree to which market prices reflect all available information, which is essential for the Law of One Price to function effectively.