key term - Law of One Price

Definition

The law of one price states that in the absence of transportation costs and trade barriers, identical goods should sell for the same price when expressed in a common currency. This principle underpins the concept of purchasing power parity, highlighting that exchange rates should adjust to ensure that goods cost the same across different countries when converted into a common currency.

5 Must Know Facts For Your Next Test

1. The law of one price is a theoretical concept that relies on the assumptions of no transaction costs and perfect competition.
2. If the law of one price holds true, it implies that arbitrage opportunities will arise when prices differ across markets, leading traders to buy in cheaper markets and sell in more expensive ones until prices converge.
3. Differences in prices for the same good can persist due to transportation costs, tariffs, taxes, and other barriers to trade.
4. The law of one price helps explain how exchange rates should move over time in response to changes in relative prices between countries.
5. In real-world applications, factors like consumer preferences and local market conditions can prevent the law of one price from holding perfectly.

Review Questions

• How does the law of one price support the concept of purchasing power parity?
  • The law of one price is a foundational idea behind purchasing power parity (PPP), as it asserts that identical goods should have the same price in different locations when adjusted for exchange rates. This principle implies that if there are discrepancies in prices, market forces will drive adjustments through arbitrage. Therefore, PPP uses the law of one price to predict how exchange rates will change based on differences in price levels between countries.
• What role does arbitrage play in maintaining the law of one price in international markets?
  • Arbitrage is crucial for enforcing the law of one price because it allows traders to exploit price discrepancies for identical goods across different markets. When an item is priced lower in one market compared to another, arbitrageurs will purchase it from the cheaper market and sell it at a higher price where it is more expensive. This process continues until prices align across markets, demonstrating how arbitrage serves as a corrective mechanism within the framework of the law of one price.
• Evaluate the limitations of the law of one price and its implications for international trade.
  • While the law of one price provides a useful benchmark for understanding pricing dynamics, its practical limitations must be considered. Factors such as transportation costs, tariffs, taxes, and local demand variations can create significant price differences that prevent the law from holding true. Additionally, variations in product quality and consumer preferences across markets may lead to persistent pricing disparities. These limitations highlight challenges in international trade, as they complicate predictions about exchange rate movements and pricing strategies for businesses operating globally.

Related terms

Purchasing Power Parity (PPP): A theory that suggests that in the long run, exchange rates should adjust so that identical goods have the same price in different countries.

Arbitrage: The practice of taking advantage of price differences between markets by buying low in one market and selling high in another.

Nominal Exchange Rate: The rate at which one currency can be exchanged for another without adjusting for inflation or differences in price levels between countries.