Law of One Price - Explained
What is the Law of One Price?
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Table of ContentsWhat is the Law of One Price?How does the Law of One Price Occur?Academic Research on the Law of One Price
What is the Law of One Price?
The Law of One Price is an economic theory that addresses the cost of identical goods in separate markets. It rests upon the idea that specific factors cause price disparities across markets.
How does the Law of One Price Occur?
The law states that identical goods being sold in different markets at the same time will sell for the same price if the following conditions are present:
- Fair and Open Competition (forces of supply and demand are in effect and constant);
- No Trade Frictions (such as tariffs, transportation fees, or transaction costs);
- The Price is able to fluctuate freely (there is no ability for buyers or sellers to manipulate prices);
- The same currency is used for the purchase (with no factors affecting currency valuation across markets).
If these attributes are present, forces of supply and demand will create a homogenous price across markets. It assumes that, if prices vary across markets, individuals will purchase more of the goods in the market at a lower price and sell it in the other market at a higher price. The lower-price market experiences higher demand - pushing up the price at the current level of supply. The higher-priced market experiences increased supply - thus lowering demand and price accordingly. The practice of buying and selling at differing prices across markets is known as "Arbitrage". Eventually, the markets will reach equilibrium and arrive at the same price for the good This theory is the basis for the measure of Purchase Price Parity across markets employing unique currencies. Per this theory, given the presence of the above-mentioned conditions, it should cost the same value in a given marketplace to purchase a good. That is, if two separate currencies are used to purchase the same good at the same time, the amount paid in one currency should represent the exact same value in the other currency. It is important to remember that the law of one price is a theory that rarely materializes in practice - as the required conditions are rarely present. Notably, prices of goods vary in a given market at a particular time. It requires the ability to buy and sell in all markets at the same time to carry out the necessary arbitrage.
- Purchasing Power Parity (PPP)
- Relative Purchasing Power Parity
- Law of One Price
- Balassa-Samuelson Effect