Question

1. Define the law of one price carefully, noting its fundamental assumptions. Why are these assumptions so difficult to apply in the real world in order to apply the theory?

Answer 1

The law of One price is the economic theory that the price of a given security commodity or is it has the same price when exchange rates are taken into consideration the law of One price is another way of stating the concept of purchasing power parity the law of One price exist due to orbit Raj opportunities. Is the price of a security commodity or acid is different in two different markets then an arbitrageur purchases the assets in the cheaper market and sells it their prices are higher when the purchasing power parity doesn't hold arbitrage profits will persist until the price converges across the market. The law of One price is in the place to prevent investors from taking advantage of price disparity between markets in and situation known as arbitrage. In Efficient market the occurrence of arbitrage opportunities are low most often caused by an event causing a sudden shift occurring in one market before the other markets are affected. When dealing in commodities the cost to transport the goods must be included resulting in different prices when commodities from two different locations are examined if the difference going beyond the transportation cost this can be a sign of shortage or access within a particular region.

Assumptions of law of One price law of One price states that in equilibrium conditions the price of a commodity will be same all over the world because if it is not then arbitrageur will drive the price to word equilibrium by buying in the cheaper market and sending in a dearer market. However it is based on certain assumptions which are as follows

The law of One price assumes that there is no restriction on the movement of goods implying that there is no crib by any country in the form of Ban as well as Kota on export and import and international trade can take place between various countries.

It also assume there is no traffic imposed by the countries also there are no transaction cost associated with buying and selling of goods in various countries.

It also has used the absence of transportation cost which are associated with the export and import of goods in order to be law of One price to be valid as can be seen that above assumption in Real world seldom happens because transportation costs are always there and also some country do not allow international trade to happen with other countries due to political reasons however this theory still holds importance and it still laid the foundation for determination of exchange rates of various country.

The assumptions become difficult to apply in the real world in order to apply the theory because this theory has assumptions that cannot be really applied in the real life assume different prices for a single identical goods in two locations no transport cost no economic barriers between both the arbitrage mechanism can now be performed by both the supply and the demand all the sellers have intensive to sell their goods in the higher price location driving up supply in that location and reducing supply in the lower priced location if demand remains constant the highest supply will force prices 2 degrees in the higher price location by the lower supply in the alternative location will drive up the prices conversely if all the consumers move to lower price location in order to buy the good at the lower price demand will increase in lower priced and the assuming constant supply in both location price will increase. Since it is difficult to find in real life where there is no movement of goods there are no transportation cost and no economic barriers.