The law of one price is an economic concept that asserts that the price of an identical asset or commodity will converge to be the same globally, regardless of location, when certain ideal conditions are met.
This theory stands on the premise of a frictionless market, where transaction costs, transportation costs, legal restrictions are nonexistent, and currency exchange rates are consistent. In such an environment, the opportunity of arbitrage would naturally eliminate price differences across different locations.
Arbitrage serves as the equalizer in this scenario, where a trader buys the asset where it’s cheaper and sells it where it’s more expensive. Over time, market equilibrium forces work to harmonize asset prices globally.
Key Insights
- Price Uniformity: According to the law of one price, absent any market frictions, the price for any given asset will tend to be the same worldwide.
- Arbitrage Opportunities: Arbitrage plays a crucial role in aligning prices through buying low in one market and selling high in another.
- Market Equilibrium: Forces of supply and demand contribute to price convergence, resulting in a balanced market state.
Building Blocks of Global Price Parity
Central to the understanding of the law of one price is the concept of purchasing power parity, which argues that two different currencies will have equivalent value when a basket of identical goods is priced the same in both currencies. This principle aims to standardize purchasing power across the global landscape.
In practice, various transactional frictions and access limitations complicate achieving purchasing power parity. Nonetheless, the theory offers a framework for regular recalibration and highlighting price disparities in international markets.
Example of the Law of One Price
Imagine a scenario where an asset or good is listed differently in two distinct free markets, once adjusted for currency exchange rates. An advanced arbitrageur steps in, purchasing the asset in the cheaper market and then unloading it in the pricier market, seamlessly earning a profit until prices balance out.
For instance, if a certain security sells for $10 in Market A but goes for an equivalent of $20 in Market B, arbitrageurs will purchase it in Market A and retail it for $20 in Market B. This plays out with virtually no risk involved, providing prices adapt according to emerging supply and demand dynamics. Eventually, the increased demand in Market A will raise its prices while heightened supply in Market B will cause prices to fall, achieving price parity.
Real-World Challenges to the Law of One Price
In the practical world, several factors can violate the idealized assumptions of the law of one price, creating perpetuating price differentials across various markets:
Transportation Costs
The cost of transporting commodities or physical goods can result in different prices due to geographical disparities. When transportation expenses outweigh the associated cost differences in commodities across regions, it typically signifies supply and demand vagrancies within those locales. This logic applies to any job necessitating physicalation movement and employment requiring physical presence.
Transaction Costs
Another hurdle is the heterogeneity in transaction costs. Different markets exhibit varying degrees of transactional frictions, which then influence the price. Higher negotiation and enforcement costs lead to higher market prices compared to regions with lower transactional friction.
Legal Restrictions
Trade barriers such as tariffs, and capital controls, including labor market impediments like immigration limitations, can instigate sustained price dissimilarities. Consider tariffs felt in rubber trade—domestic tariffs would escalate its price compared to the global market despite underlying conditions recycled across transaction genres.
Market Structure
Finally, market concentration and the resultant power dynamics among buyers and sellers vary remarkably by geography. Natural monopolies or industry dominance associated with economies of scale could lead sellers to exert monopoly-like influence and manipulate prices, leading to inter-market disparities even for transportable goods.
Related Terms: arbitrage, market equilibrium, transaction costs, transportation costs, purchasing power parity.
