Law of one price

3 key takeaways

• The law of one price asserts that identical goods should sell for the same price in different markets, factoring in currency exchange rates.
• It is foundational to the concept of purchasing power parity (PPP) in international economics.
• Market inefficiencies, transportation costs, tariffs, and other barriers can cause deviations from the law of one price.

What is the law of one price?

The law of one price is a principle that posits that identical goods should have the same price when sold in different markets, provided there are no frictions like transportation costs, taxes, or tariffs. This law is based on the assumption of efficient markets, where arbitrage opportunities are quickly exploited to equalize prices across different locations.

Example

If a smartphone sells for $500 in the United States and the exchange rate between the U.S. dollar and the euro is 1:1, the law of one price suggests that the same smartphone should sell for €500 in Europe. If the price differs, arbitrageurs could buy the smartphone in the cheaper market and sell it in the more expensive market, profiting from the price difference until prices converge.

Applications and implications

Purchasing power parity (PPP)

The law of one price is integral to the concept of purchasing power parity, which extends the idea to the overall price levels of goods and services in different countries. According to PPP, exchange rates should adjust so that a basket of goods has the same price in different countries. PPP is used to compare economic productivity and standards of living between countries.

Arbitrage

Arbitrage opportunities arise when there are price discrepancies for identical goods in different markets. Traders can buy the good in the cheaper market and sell it in the more expensive market, driving prices toward equilibrium. This process helps ensure that the law of one price holds in practice.

Exchange rates

The law of one price influences exchange rate movements. If a good is cheaper in one country, demand for that good and its currency will increase, leading to an appreciation of the currency until prices equalize.

Deviations from the law of one price

Transportation costs

The cost of transporting goods between markets can cause deviations from the law of one price. If it is expensive to ship goods, the price difference between markets can persist, reflecting these transportation costs.

Tariffs and taxes

Government-imposed tariffs and taxes can create price differences between markets. These barriers to trade prevent prices from equalizing by adding extra costs to the goods.

Market inefficiencies

In some cases, market inefficiencies such as lack of information, market segmentation, or monopolistic practices can prevent the law of one price from holding. These inefficiencies can lead to sustained price differences for identical goods in different markets.

Non-tradable goods

Certain goods and services are non-tradable, meaning they cannot be easily transported or sold across borders. Examples include real estate and personal services. For such goods, the law of one price does not apply.

Related topics

• Purchasing power parity (PPP): Understand how PPP extends the law of one price to overall price levels and its implications for exchange rates and economic comparisons.
• Arbitrage: Learn about the practice of exploiting price differences in different markets to achieve risk-free profits and its role in market efficiency.
• Efficient market hypothesis: Explore the theory that financial markets are efficient, meaning that prices reflect all available information and arbitrage opportunities are quickly eliminated.

The law of one price is a fundamental concept in economics that underpins much of international trade theory and exchange rate analysis. While real-world factors can cause deviations, the principle provides a benchmark for understanding price relationships across different markets.