What is the law of the single price?
The law of the single price is an economic concept which stipulates that the price of an identical asset or commodity will have the same price worldwide, regardless of location, when certain factors are taken into account.
The law of the single price takes into account a frictionless market, where there are no transaction costs, transport or legal restrictions, the exchange rates are the same and there is no manipulation of price by buyers or sellers. The law of one price exists because the differences between the prices of assets in different places would eventually be eliminated due to the opportunity for arbitrage.
The arbitrage opportunity would be realized by which an operator would buy the asset on the market, it is available at a lower price, and then sell it on the market where it is available at a higher price. Over time, market equilibrium forces would align asset prices.
Key points to remember
- The law of the single price stipulates that in the absence of friction between world markets, the price of any asset will be the same.
- The law of the single price is obtained by eliminating price differences by means of arbitrage between markets.
- Market equilibrium forces would eventually converge the price of the asset.
Understanding the law of the single price
The law of the single price is the foundation of purchasing power parity. Purchasing power parity indicates that the value of two currencies is equal when a basket of identical goods has the same price in both countries. It ensures that buyers have the same purchasing power in world markets.
In reality, purchasing power parity is difficult to achieve, due to the various costs of trade and the inability to access markets for some people.
The purchasing power parity formula is useful in that it can be applied to compare prices in markets that trade in different currencies. As exchange rates can change frequently, the formula can be recalculated regularly to identify pricing errors in the various international markets.
Example of the law of the single price
If the price of a good or economic security is inconsistent on two different free markets after taking into account the effects of exchange rates, an arbitrator will buy the asset on the cheapest market and sell it on the market. where the prices are higher. When the law of the single price applies, arbitrage benefits such as these persist until the price converges between the markets.
For example, if a particular security is available for $ 10 in market A but sells for the equivalent of $ 20 in market B, investors could buy the security in market A and sell it immediately for $ 20 in the market. market B, making a profit of $ 10 without any real risk or displacement of the markets.
As securities in market A are sold in market B, prices in both markets are expected to change with changes in supply and demand, all other things being equal. The increase in demand for these titles on market A, where it is relatively cheaper, should lead to an increase in its price in this country.
Conversely, an increase in supply on market B, where the security is sold at a profit by the arbitrator, should cause its price to fall. Over time, this would lead to a balancing of the price of the security on the two markets, bringing it back to the state suggested by the law of the single price.
One price law violations
In the real world, the assumptions established in the law of the single price often do not hold, and persistent price differentials for many types of goods and assets can be readily observed.
When trading in commodities or any physical good, the cost of transporting them must be included, which results in different prices when products from two different locations are examined.
If the difference in transportation costs does not take into account the difference in commodity prices between regions, it may be a sign of a shortage or surplus in a particular region. This applies to any property that must be physically transported from one geographic location to another rather than simply transferred as title from one owner to another. It also applies to wages for any job where the worker must be physically present on the site to perform the work.
Since transaction costs exist and may vary from market to market and geographic region, prices for the same product may also vary from market to market. When transaction costs, such as the costs of finding an appropriate commercial consideration or the costs of negotiating and performing a contract, are higher, the price of a good will tend to be higher than in other markets where transaction costs are lower.
Legal barriers to trade, such as tariffs, capital controls or, in the case of wages, immigration restrictions, can lead to persistent price differentials rather than a single price. These will have an effect similar to transportation and transaction costs, and could even be considered a type of transaction cost. For example, if a country imposes a tariff on importing rubber, domestic prices of rubber will tend to be higher than the world price.
Since the number of buyers and sellers (and the ability of buyers and sellers to enter the market) may vary between markets, market concentration and the ability of buyers and sellers to set prices may also vary.
A seller who enjoys high market power due to natural economies of scale in a given market can act as a monopoly price fixer and charge a higher price. This can lead to different prices for the same product in different markets, even for otherwise easily transportable goods.