Law of one price

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The law of one price (LoP) is an economic concept which posits that "a good must sell for the same price in all locations".[1][2][3][4][5][6][7] This law is derived from the assumption of the inevitable elimination of all arbitrage.[additional citation needed]

The law of one price constitutes the basis of the theory of purchasing power parity, an assumption that in some circumstances (for example, as a long-run tendency) it would cost exactly the same number of, for example, US dollars to buy euros and then to use the proceeds to buy a market basket of goods as it would cost to use those dollars directly in purchasing the market basket of goods.[additional citation needed]

History

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The law of one price has been applied towards the analysis of many public events such as:

  • In 2015, The International Monetary Fund holds that the law of one price holds for most tradeable products in Brazil but does not apply in the same way to its non-tradeable goods.[8]
  • A director of the Council on Foreign Relations held in 2013 that the then-current Apple iPad mini followed the law of one price, as far as its price nearly reached the same US dollar exchange rate in each applicable country.[9]
  • Indonesian governmental oil subsidies against oil smugglers; The smugglers selling stolen government-discounted oil back to its market rate.[10]
  • An apparent violation of the law involving international Royal Dutch/Shell stocks. After merging in 1907, holders of Royal Dutch Petroleum (traded in Amsterdam) and Shell Transport shares (traded in London) were entitled to 60% and 40% respectively of all future profits. Royal Dutch shares should therefore automatically have been priced at 50% more than Shell shares. However, they diverged from this by up to 15%.[11][additional citation needed] This discrepancy disappeared with their final merger in 2005.[citation needed]

Overview

The intuition behind the law of one price is based on the assumption that differences between prices are eliminated by market participants taking advantage of arbitrage opportunities.[12][additional citation needed]

Example in regular trade

Assume different prices for a single identical good in two locations, no transport costs and no economic barriers between both locations. The arbitrage mechanism can now be performed by both the supply and/or the demand site: All sellers have an incentive to sell their goods in the higher-priced location, driving up supply in that location and reducing supply in the lower-priced location.

If demand remains constant, the higher supply will force prices to decrease in the higher-priced location, while the lowered supply in the alternative location will drive up prices there.

Conversely, if all consumers move to the lower-priced location in order to buy the good at the lower price, demand will increase in the lower-priced location, and - assuming constant supply in both locations - prices will increase, whereas the decreased demand in the higher-priced location leads the prices to decrease there.[13]

Both scenarios result in a single, equal price per homogeneous good in all locations.[12][additional citation needed]

In efficient markets the convergence on one price is instant.[citation needed] For further discussion, please refer to Rational pricing.

Example in formal financial markets

Commodities can be traded on financial markets, where there will be a single offer price (asking price), and bid price. Although there is a small spread between these two values the law of one price applies (to each).

No trader will sell the commodity at a lower price than the market maker's bid-level or buy at a higher price than the market maker's offer-level.[12][additional citation needed] In either case moving away from the prevailing price would either leave no takers, or be charity.[citation needed]

In the derivatives market the law applies to financial instruments which appear different, but which resolve to the same set of cash flows; see Rational pricing. Thus:

"A security must have a single price, no matter how that security is created. For example, if an option can be created using two different sets of underlying securities, then the total price for each would be the same or else an arbitrage opportunity would exist.[5]"

A similar argument can be used by considering arrow securities as alluded to by Arrow and Debreu (1944).

Non-application

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  • The law does not apply intertemporally, so prices for the same item can be different at different times in one market. The application of the law to financial markets is obscured by the fact that the market maker's prices are continually moving in liquid markets. However, at the moment each trade is executed, the law is in force (it would normally be against exchange rules to break it).[citation needed]
  • The law also need not apply if buyers have less than perfect information about where to find the lowest price. In this case, sellers face a tradeoff between the frequency and the profitability of their sales. That is, firms may be indifferent between posting a high price (thus selling infrequently, because most consumers will search for a lower one) and a low price (at which they will sell more often, but earn less profit per sale).[14][additional citation needed]
  • The Balassa-Samuelson effect argues that the law of one price is not applicable to all goods internationally, because some goods are not tradable. It argues that the consumption may be cheaper in some countries than others, because nontradables (especially land and labor) are cheaper in less developed countries. This can make a typical consumption basket cheaper in a less developed country, even if some goods in that basket have their prices equalized by international trade.[citation needed]

See also

  • Oneness (disambiguation)
  • Price
  • Gresham's law is an economic principle that states: "When a government overvalues one type of money and undervalues another, the undervalued money will leave the country or disappear from circulation into hoards, while the overvalued money will flood into circulation."
  • Engel's law is an observation in economics stating that as income rises, the proportion of income spent on food falls, even if actual expenditure on food rises.
  • Hotelling's law is an observation in economics that in many markets it is rational for producers to make their products as similar as possible.
  • Pizza Principle is the claim that "the price of a slice of pizza has matched, with uncanny precision, the cost of a New York subway ride."
  • Iron law of wages is a proposed law of economics that asserts that real wages always tend, in the long run, toward the minimum wage necessary to sustain the life of the worker.
  • Diminishing returns is the decrease in the marginal (incremental) output of a production process as the amount of a single factor of production is incrementally increased, while the amounts of all other factors of production stay constant.
  • Iron law of prohibition posits that as law enforcement becomes more intense, the potency of prohibited substances increases.
  • Okun's law can state that for every 1% increase in the unemployment rate, a country's GDP will be roughly an additional 2% lower than its potential GDP.
  • Verdoorn's law states that in the long run productivity generally grows proportionally to the square root of output.
  • Supply and demand
  • Men's underwear index
  • Hemline index
  • Big Mac index
  • Recession index
  • Christmas Price Index
  • Rational pricing
  • Price dispersion
  • Search theory

References

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  7. Mankiw, N. G. (2011). Principles of Economics (6th ed.). Mason, OH: South-Western Cengage Learning. Page 686.
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  11. Lamont, O.A. and Thaler, R.H. (2003), "Anomalies: The Law of One Price in Financial Markets". Journal of Economic Perspectives 17 (Fall 2003), pp. 191–202.
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  14. Burdett, Kenneth, and Kenneth Judd (1983), 'Equilibrium price dispersion'. Econometrica 51 (4), pp. 955-69.
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Further reading