Back to: ECONOMIC ANALYSIS & MONETARY POLICY
Law of One Price (LOOP) Definition
The Law of One Price is an economic theory that addresses the cost of identical goods in separate markets. It rests upon the idea that specific factors cause price disparities across markets.
A Little More on What is the Law of One Price
The law states that identical goods being sold in different markets at the same time will sell for the same price if the following conditions are present:
- Fair and Open Competition (forces of supply and demand are in effect and constant);
- No Trade Frictions (such as tariffs, transportation fees, or transaction costs);
- The Price is able to fluctuate freely (there is no ability for buyers or sellers to manipulate prices);
- The same currency is used for the purchase (with no factors affecting currency valuation across markets).
If these attributes are present, forces of supply and demand will create a homogenous price across markets. It assumes that, if prices vary across markets, individuals will purchase more of the goods in the market at a lower price and sell it in the other market at a higher price. The lower-price market experiences higher demand – pushing up the price at the current level of supply. The higher-priced market experiences increased supply – thus lowering demand and price accordingly. The practice of buying and selling at differing prices across markets is known as “Arbitrage”. Eventually, the markets will reach equilibrium and arrive at the same price for the good
This theory is the basis for the measure of Purchase Price Parity across markets employing unique currencies. Per this theory, given the presence of the above-mentioned conditions, it should cost the same value in a given marketplace to purchase a good. That is, if two separate currencies are used to purchase the same good at the same time, the amount paid in one currency should represent the exact same value in the other currency.
It is important to remember that the law of one price is a theory that rarely materializes in practice – as the required conditions are rarely present. Notably, prices of goods vary in a given market at a particular time. It requires the ability to buy and sell in all markets at the same time to carry out the necessary arbitrage.
Academic Research on the Law of One Price
How far can we push the” law of one price“?. Isard, P. (1977). The American Economic Review, 67(5), 942-948. This paper proves that changes in exchange rates significantly shifted the prices of narrowly defined domestic and foreign manufactured goods which have prices that can be easily matched.
Does the law of one price really hold for commodity prices?, Ardeni, P. G. (1989). American Journal of Agricultural Economics, 71(3), 661-669. This paper argues that the assumption that commodity prices are perfectly arbitraged in the long run is counterfactual and that most of the empirical evidence provided in its support is flawed and affected by econometric shortcomings in the data.
Convergence to the law of one price without trade barriers or currency fluctuations, Parsley, D. C., & Wei, S. J. (1996). The Quarterly Journal of Economics, 111(4), 1211-1236. This paper presents an upper bound estimate of the convergence rate to Purchasing Power Parity using a sample of 51 prices from 48 cities in the US.
Some empirical evidence on commodity arbitrage and the law of one price, Richardson, J. D. (1978). Journal of International Economics, 8(2), 341-351. This article presents several conclusions derived from a regression study of disaggregated commodity arbitrage between the US and Canada.
Market integration and convergence to the Law of One Price: evidence from the European car market, Goldberg, P. K., & Verboven, F. (2005). Journal of international Economics, 65(1), 49-73. This is an investigation of integration’s relationship with price convergence in international markets through the exploitation of the special experiment of European market integration.
Margin-based asset pricing and deviations from the law of one price, Garleanu, N., & Pedersen, L. H. (2011). The Review of Financial Studies, 24(6), 1980-2022. This paper presents the characterization of the required returns of securities by their betas and margin requirements in a model with heterogeneous-risk-aversion agents facing margin constraints.
Some further evidence on the law of one price: The law of one price still holds. Baffes, J. (1991). American Journal of Agricultural Economics, 73(4), 1264-1273. This paper tests the law of one price for seven commodities contained in four countries through a practical consideration of the transaction costs.
Why does the law of one price fail? An experiment on index mutual funds. Choi, J. J., Laibson, D., & Madrian, B. C. (2009). The Review of Financial Studies, 23(4), 1405-1432. This study carries out various experiments to evaluate the reason most individuals invest in high-fee index funds.
Anomalies: The law of one price in financial markets. Lamont, O. A., & Thaler, R. H. (2003). Journal of Economic Perspectives, 17(4), 191-202. This paper presents evidence on the various examples of violations of the law of one price and then analyzes the causes of these violations to determine if they all result from some limits of the intervention of rational arbitrageurs.
The law of one price—a case study, Haskel, J., & Wolf, H. (2001). Scandinavian Journal of Economics, 103(4), 545-558. This article investigates the extent and degree of violations of the law on one price through the use of retail transaction prices belonging to a multinational retailer.
The law of one price: evidence from the transitional economy of China, Fan, C. S., & Wei, X. (2006). The Review of Economics and Statistics, 88(4), 682-697. This is an application of econometric methods of panel unit root tests and nonlinear mean reversion in the investigation of convergence of price in China which is the biggest transitional economy in the world.