Law of One Price

Definition

The law of one price is an economic principle that states that in an efficient market, the price of an identical good or asset must be the same across all locations, after accounting for the costs of transportation, tariffs, and other transaction costs. This principle is based on the idea that if the price of a good varies across locations, arbitrageurs will exploit the price difference by buying the good in the lower-priced market and selling it in the higher-priced market, thereby driving the prices towards convergence.

5 Must Know Facts For Your Next Test

1. The law of one price is a fundamental principle in international trade and finance, as it helps to explain how exchange rates are determined.
2. The law of one price assumes that there are no barriers to trade, such as tariffs, transportation costs, or other transaction costs, and that markets are perfectly competitive.
3. If the law of one price does not hold, it creates opportunities for arbitrage, where traders can profit by buying the good in the lower-priced market and selling it in the higher-priced market.
4. The law of one price is closely related to the concept of purchasing power parity (PPP), which states that the exchange rate between two currencies should equalize the prices of an identical basket of goods and services in those countries.
5. The law of one price is an important assumption in the determination of foreign exchange rates, as it helps to explain how exchange rates adjust to changes in supply and demand in foreign exchange markets.

Review Questions

• Explain how the law of one price relates to the determination of exchange rates in foreign exchange markets.
  • The law of one price is a fundamental principle that helps to explain how exchange rates are determined in foreign exchange markets. According to the law of one price, the price of an identical good or asset should be the same across all locations, after accounting for the costs of transportation, tariffs, and other transaction costs. If this condition is not met, it creates opportunities for arbitrage, where traders can profit by buying the good in the lower-priced market and selling it in the higher-priced market. This arbitrage activity helps to drive the prices towards convergence and, in turn, influences the determination of exchange rates in foreign exchange markets.
• Describe how the concept of purchasing power parity (PPP) is related to the law of one price.
  • The law of one price is closely related to the concept of purchasing power parity (PPP). PPP states that the exchange rate between two currencies should equalize the prices of an identical basket of goods and services in those countries. This is based on the idea that if the law of one price holds, then the prices of identical goods should be the same across countries, after accounting for the exchange rate. If the law of one price does not hold, it can lead to deviations from PPP, as the exchange rate may not accurately reflect the relative prices of goods and services in the two countries. The relationship between the law of one price and PPP is an important consideration in the determination of exchange rates and the analysis of international trade and finance.
• Analyze the role of market integration in the context of the law of one price, and explain how it affects the convergence of prices across locations.
  • The law of one price assumes that markets are integrated, meaning that the prices of identical goods or assets are equalized across locations, after accounting for transaction costs. In integrated markets, the law of one price holds, and any price differences between locations will be exploited by arbitrageurs, who will buy the good in the lower-priced market and sell it in the higher-priced market. This arbitrage activity helps to drive the prices towards convergence, ensuring that the law of one price is maintained. However, if markets are not fully integrated due to barriers to trade, such as tariffs, transportation costs, or other transaction costs, the law of one price may not hold, and prices can diverge across locations. The degree of market integration, therefore, plays a crucial role in determining the extent to which the law of one price is observed in practice and how it affects the convergence of prices across different locations.

Related terms

Arbitrage:

The practice of taking advantage of a price difference between two or more markets by simultaneously buying and selling the same or equivalent assets.

Purchasing Power Parity (PPP):

An economic theory that states that the exchange rate between two currencies should equalize the prices of an identical basket of goods and services in those countries.

Integrated Markets: Markets where the prices of identical goods or assets are equalized across locations, after accounting for transaction costs.