What is the law of the single price?
The law of one price is an economic concept that states that the price of an identical asset or commodity will have the same price overall, regardless of location, when certain factors are taken into account.
The law of one price allows for a frictionless market, where there are no transaction fees, transport or legal restrictions, the exchange rates are the same, and where there are no price manipulation by buyers or sellers. The law of one price exists because the differences between the prices of assets in different places would eventually be eliminated due to the opportunity for arbitrage.
The arbitrage opportunity would be realized where a trader would buy the asset in the market where it is available at a lower price and then sell it in the market where it is available at a higher price. Over time, market equilibrium forces would align the prices of the asset.
Key points to remember
- The law of one price states that in the absence of friction between world markets, the price of any asset will be the same.
- The law of one price is achieved by eliminating price differences through arbitrage opportunities between markets.
- Market equilibrium forces would eventually converge the price of the asset.
Understanding the law of one price
The law of one price is the foundation of purchasing power parity. Purchasing power parity states that the value of two currencies is equal when a basket of identical goods has the same price in both countries. It ensures that buyers have the same purchasing power in world markets.
In reality, purchasing power parity is difficult to achieve, due to the various costs associated with trade and the inability to access markets for some individuals.
The purchasing power parity formula is useful in that it can be applied to compare prices in markets that trade in different currencies. As exchange rates can change frequently, the formula can be recalculated periodically to identify pricing errors in various international markets.
Example of the law of one price
If the price of a good or economic security is inconsistent in two different free markets after considering the effects of exchange rates, then to make a profit, an arbitrageur will buy the asset in the cheapest market and will sell in the market where the prices are higher. When the law of one price applies, arbitrage profits such as these will persist until the price converges in the markets.
For example, if a particular security is available for $ 10 in market A but sells for the equivalent of $ 20 in market B, investors could buy the security in market A and immediately sell it for $ 20 on market B. market B, thus making a profit of $ 10 without any real risk or movement of the markets.
As Market A securities are sold in Market B, prices in both markets should change based on changes in supply and demand, all other things being equal. An increased demand for these securities in Market A, where they are relatively cheaper, should lead to an increase in their price in this market.
Conversely, an increased supply on market B, where the security is sold at a profit by the arbitrageur, should lead to a drop in its price. Over time, this would lead to a price balancing of the security in both markets, returning it to the state suggested by the law of one price.
Violations of the law of one price
In the real world, the assumptions built into the law of one price often do not hold up, and persistent price differentials for many types of goods and assets can be easily observed.
When it comes to goods or any physical good, the cost of transporting them should be included, resulting in different prices when goods from two different locations are examined.
If the difference in transportation costs does not take into account the difference in commodity prices between regions, it may be a sign of a shortage or excess in a particular region. This applies to any good that needs to be physically transported from one geographic location to another rather than simply transferred in title from one owner to another. It also applies to wages for any job where the worker must be physically present on the job site to perform the work.
Since transaction costs exist and can vary across markets and geographic regions, prices for the same good can also vary from market to market. When transaction costs, such as the costs of finding a suitable commercial consideration or the costs of negotiating and fulfilling a contract, are higher, the price of a good will tend to be higher there than. in other markets where transaction costs are lower.
Legal barriers to trade, such as tariffs, capital controls or, in the case of wages, immigration restrictions, can lead to persistent price differentials rather than a single price. These will have a similar effect on transport and transaction costs, and could even be considered a type of transaction cost. For example, if a country imposes a tariff on the import of rubber, domestic rubber prices will tend to be higher than the world price.
Since the number of buyers and sellers (and the ability of buyers and sellers to enter the market) may vary from market to market, market concentration and the ability of buyers and sellers to pricing may also vary.
A seller who enjoys a high degree of market power due to natural economies of scale in a given market may act as a monopolistic price fixer and charge a higher price. This can lead to different prices for the same good in different markets, even for otherwise easily transportable goods.