Table of Contents
- What Is the Law of One Price?
- Understanding the Law of One Price
- Example of the Law of One Price
- The Big Mac Index
- Exceptions to the Law of One Price
- Transportation Costs
- Transaction Costs
- Legal Restrictions
- Market Structure
- What Are the Assumptions of the Law of One Price?
- Why Is the Law of One Price Important?
- What Does the Law of One Price Mean in Finance?
- The Bottom Line
What Is the Law of One Price?
Let me explain the law of one price to you directly: it's an economic concept that says the price of an identical asset or commodity should be the same everywhere in the world, no matter the location, once you account for certain factors.
I consider a frictionless market in this principle, where there are no transaction costs, no transportation costs, no legal restrictions, the exchange rates are identical, and there's no price manipulation by buyers or sellers. This law holds because any price differences between locations create arbitrage opportunities that eventually eliminate those differences.
Here's how it works: a trader can buy the asset where it's cheaper and sell it where it's more expensive. Over time, these actions force market equilibrium, aligning the prices.
Key Takeaways
- The law of one price states that without friction between global markets, any asset's price will be the same everywhere.
- It eliminates price differences through arbitrage between markets.
- Market equilibrium forces eventually make asset prices converge.
Understanding the Law of One Price
You should know that the law of one price forms the foundation of purchasing power parity. This parity means two currencies have equal value when a basket of identical goods costs the same in both countries, ensuring the same purchasing power globally.
In practice, achieving purchasing power parity is tough due to trading costs and limited market access for some people.
The formula for purchasing power parity lets you compare prices across markets using different currencies. Since exchange rates change often, you can recalculate it regularly to spot mispricings in international markets.
Example of the Law of One Price
Consider this: if a good or security has inconsistent prices in two free markets after adjusting for exchange rates, an arbitrageur buys it cheap in one market and sells it high in the other to profit. This continues until prices converge, upholding the law of one price.
For instance, if a security costs $10 in Market A but $20 equivalent in Market B, you could buy in A and sell in B for a $10 profit with no real risk. As this happens, supply and demand shift: prices rise in A due to higher demand and fall in B due to higher supply, eventually balancing out.
The Big Mac Index
Take the Big Mac Index as an informal gauge of trade barriers and geographic frictions. It looks at the cost of McDonald's Big Mac, which is nearly identical worldwide, but prices vary from $8.17 to $2.39 due to differences in labor, agriculture, and regulations.
Exceptions to the Law of One Price
In the real world, the assumptions of the law often don't hold, leading to ongoing price differences for goods and assets.
Transportation Costs
When dealing with physical goods, you have to factor in transportation costs, which create price variations between locations. If these costs don't explain the price difference, it might indicate a shortage or excess in a region. This applies to any good that needs physical transport or to jobs requiring on-site presence.
Transaction Costs
Transaction costs vary by market and region, so prices for the same good differ. Higher costs to find partners or negotiate contracts mean higher prices in those markets.
Legal Restrictions
Legal barriers like tariffs, capital controls, or immigration rules cause persistent price differences. Think of them as transaction costs; for example, a tariff on imported rubber raises domestic prices above the world price.
Market Structure
The number of buyers and sellers varies, affecting market concentration and pricing power. A seller with monopoly-like power from economies of scale can charge more, leading to different prices even for transportable goods.
What Are the Assumptions of the Law of One Price?
The law assumes no transaction costs or trade barriers, with free competition. Under these, commodity prices equalize as consumers seek the cheapest options.
Why Is the Law of One Price Important?
It's key for purchasing power parity, showing if currencies are under- or overvalued based on price differences for the same goods after exchange rates.
What Does the Law of One Price Mean in Finance?
In finance, it means equivalent securities should have the same value, regardless of creation method. A synthetic security should match a physical one's price; otherwise, arbitrage opportunities arise for traders.
The Bottom Line
To wrap this up, the law of one price says equivalent goods should have the same prices across markets without major costs or barriers. In reality, market structures and demand differences often cause geographic price variations.
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