Question

According to the Law of One Price, assuming there are no transport costs and freecompetition exists, identical goods sold in different locations will have the same price.2Using the concepts of Arbitrage and Supply & Demand, explain why this must be thecase – at least in theory. Your answer should include a diagram. Why doesn’t the Lawof One Price hold in real life?

Answer 1

Law of One Price: The law states that, given there are no transportation costs, free competition and free trade i.e., no quotas or tariffs, the identical goods will be sold for same prices, adjusting for exchange rate, in two different locations.

If not the case, then the trader may purchase in from the location where it is available for a lesser price and will sell it in the market with the higher prices, so as to earn profits. This process is called as arbitrage.

For example, a good is available for $100 in US and Rs 6000 in India, exchange rate being Rs 60/$. The price of the good is same in both the countries, after taking exchange rate into consideration. If the price in US is lesser, the trader would buy it US and sells in India to earn profits. This will happen till the price in both the countries are same for the same commodity.

In the diagram below, the equilibrium of demand and supply gives the price P₁^* in US and P₁ in India for the same commodity Good_1. P₁ < P₁^* . This reduced price in India increases the demand for the product in India raising its prices in the country. At the same time, the trader will sell the product at higher prices in US, brought from India at lower prices, thereby registering profits. This increases the supply in US and lowering prices in the country. This process will happen until the price in both the countries equals at P.

The law holds because of arbitrage opportunities. In the real world, it may not hold. The reasons could be many such as in real life the transportation costs do exist, there are transaction costs for each transaction carried out by the trader, trade barriers too exist and also it depends on the availability of substitutes in the market.