What Is the Law of One Price?

The law of one price is a manifestation of the theory of absolute purchasing power parity. It was proposed by Friedman (1953), a representative of the monetary school. The law of one price can be simply expressed as: when trade is open and transaction costs are zero, no matter where the same goods are sold, the price of the goods expressed in the same currency is the same. This reveals a basic link between domestic commodity prices and exchange rates.

Law of one price

The law of one price states that in the absence of transport costs and official trade barriers

Examples of exchange rates

When US $ 1 = 6.8 yuan, goods sold for one US dollar in the United States should sell one yuan for 6.8 yuan in China, that is, the price of one US dollar should also be one dollar. In this example, whether the product is overvalued or undervalued in China or the United States, it will cause the product to move in both markets until the prices in both markets are completely the same. The formula is: = P a / P b

Where e is

1. Comparative countries have implemented the same degree

The law of one price is to evaluate costs and benefits to calculate

Psychological factors

In different parts of the world, even if the quality of the goods is exactly the same, the value evaluation is not the same. Because the intrinsic value is reflected in the subjective cognition of the buyer and the seller, and objectively through the supply and demand prices. Subjective cognition is mainly influenced by cultural background. For example, the acceptance of Starbucks coffee varies around the world. Therefore, these psychological factors will affect the buyer's demand, prompting the supplier to use different pricing methods, resulting in the actual situation may not agree with the theory.

time difference

This law does not apply to time-dependent situations, so prices in the same market will change over time. However, the situation in financial markets is exceptional, as prices set by market makers in liquid markets will also continue to move. However, the law of one price is still valid when each order is executed.

The best example is carry trade, which is based on the existence of different interest rates in different currencies. This difference in interest rates causes the exchange rates of the two currencies to move in opposite directions. Once the investor finds the difference in interest rates, there is obviously an arbitrage opportunity. He only needs to borrow a currency with a low interest rate and convert it into a currency with a high interest rate, earn extra interest from it, and then return the principal measured in the original currency to complete a sum Carry trades. In the process, interest rates change over time. As more and more investors seize this risk-free arbitrage opportunity and earn high interest in foreign exchange trading, the difference in interest rates between the two currencies will no longer exist because the foreign exchange market The exchange rate has been promoted by many transactions to restore equilibrium. The nature of the interest rate is the price or time cost of borrowing funds. In the end, the same interest rate of the two currencies also conforms to the law of one price.

Information asymmetry

The law of one price does not apply if the transaction has asymmetric information and the buyer cannot know who the lowest price is. In this case, the seller needs to weigh the trade frequency and profitability. Companies may set high prices or low prices. The former results in inactive transactions because consumers always want to search for the lowest price. The latter increases corporate sales but generates less profit than before.

Balassa-Samuelson effect

The Balassa-Samuelson effect believes that the law of one price is not necessarily universal for all goods in the world, because some goods cannot be traded outwards. The theory believes that consumption in some countries is cheaper than in other countries, due to the relatively cheap non-tradable goods, especially land and labor, of underdeveloped countries. This has led to underdeveloped countries with a typical basket of cheap consumer goods, although the prices of some of them have been flattened by the effects of international trade activities.

Examples of violations of the law

An example often cited by scholars is Royal Dutch Petroleum and Shell stocks. The two companies merged in 1907, Royal Dutch Petroleum's stock was traded in Amsterdam, and Shell's stock was listed in London. The original business was allowed to operate independently, but the total profit of both parties must be distributed according to the ratio of six to four. As expected earnings change, KLM's stock value should therefore be equivalent to 1.5 times Shell stock value per unit. However, after the fact, the stock prices of the two companies deviated from the theoretical expectations for a long time, and the deviation percentage was as high as 15% [5] [6]. This deviation did not decline until 1999, and the final merger of the two companies ended in 2005.