Law of One Price

What is Law of One Price?

The Law of One Price (LOOP) states that the price of identical goods must remain the same worldwide irrespective of the geographical location. It occurs in the presence of free competition and price flexibility, and the absence of trade frictions.

The law explains that identical goods should have the same selling price when expressed in a common currency. The economic theory holds several assumptions and is primarily applicable in the cases of various commodities traded in the financial markets. It is also the basis for many economic theories.

• The law of one price (LOOP) is an economic theory that states that the price of identical commodities should be equal across countries.
• It is based on many assumptions like the absence of trade frictions, and presence of free competition, flexible pricing, and perfect commodity arbitrage.
• It is commonly applied to the commodities traded in the financial markets. However, it is also the basis for many economic theories.
• The violation of LOOP occurs due to transport costs, trade restrictions, and the limits placed on the level of rational arbitrageurs' intervention.

Law of One Price Explained

The law of one price states that the prices of similar products should be equal across countries, given currency exchange rate is taken into consideration. Several conditions back the law. Firstly, in the absence of trade frictions, a frictionless market is realized when there are no transaction costs, transportation costs, tariffs, and other trade barriers contributing to the cost differences. Another condition is the environment with free competition and price flexibility allowing the prices to adjust freely. Finally, the important concept associated with the LOOP is the perfect commodity arbitrage. It causes the prices of identical assets in different markets to converge hence eliminating the price differences.

One of the economic laws most often subjected to the test is the LOOP. The cointegration analysis is one of the often used techniques for testing it. Unfortunately, LOOP frequently experiences disruptions and improper applications. For instance, the LOOP is often added as the foundational element in models of international agricultural trade without first confirming the accuracy of the assumption for that specific product. It can occasionally result in false findings, affecting judgments on how to formulate policies.

Common currency strengthens the effect of LOOP, that the same good is sold in different markets but tagged with the same currency. Conversely, the strength is weak when the same good has a selling price in different currencies in different markets.

Example

Let's take a simple law of one price example: The village ABC has a local market where groceries are available. There is an enormous demand for goat milk in this village A, and the store owner sells it for $4. However, on a free weekend, the owner visits the nearby village, XYZ, and finds that their local market has the same quality goat milk for $2, which is a lower price. The owner finds it a good arbitrage opportunity and decides to buy the goat milk from village XYZ, bring it to his store and sell it. Here the market owner is playing the role of an arbitrageur by buying goat milk for $2 and selling it for $4.

However, when supply and demand shift, prices in both marketplaces should quickly fluctuate and eventually converge. Therefore, the price of this goat milk in the market of village XYZ, where it is substantially less expensive, ought to go up due to increased demand. In contrast, a rise in goat milk supply in the village ABC market, where the arbitrageur is profitably selling the milk, should decrease its price. It would eventually result in the price of milk in the two villages' marketplaces in a balanced state, restoring it to the situation specified by the LOOP. Furthermore, it shows the connection between the law of one price and arbitrage.

What Violates Law of One Price?

The LOOP is not always practical due to transport costs, trade restrictions, and the limits placed on the level of rational arbitrageurs' intervention. Factors like transportation costs, trade barriers, pricing to market, exchange rate risk, and trade regionalization, can block market arbitrage and corresponding convergence of international prices. Examples of violations of LOOP include closed-end country funds, twin shares, and corporate spinoffs.

• The violation of the LOOP is common because the theory is based on many assumptions that cannot be true in every scenario.
• If trade barriers and restrictions exist, it does not comply with the LOOP and violates its system. For example, when transactional costs and transportation charges are active, there is a visible difference in the price of commodities in two different markets.
• The complex price system, unhealthy competition, and illegal activities like hoarding, black marketing, smuggling, etc., can violate the LOOP.

Frequently Asked Questions (FAQs)

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This has been a Guide to What is Law of One Price and its Definition. We explain its examples, violations, and assumptions like arbitrage opportunities. You can learn more from the following articles -

• Gresham’s Law
• Price Discrimination
• Price Maker