Question

What is the Law of One Price?

Describe the mechanism through which the Law of One Price leads to the Theory of Purchasing Power Parity. What is the Theory of Purchasing Power Parity?

Answer 1

SOLUTION

LAW OF ONE PRICE

The law of one price (LOOP) states that in the absence of trade frictions ( such as transport costs and tarrifs ) , and under conditions of free competition and price flexibility ( where no individual sellers or buyers have the power to manipulate prices and prices can freely adjust), identical goods sold in different locations must sell in the same price when prices are expressed in a common currency. This law is derived from the assumption of the inevitavle elimination of all arbitrage.

MECHANISM THROUGH WHICH THE LAW OF ONE PRICE LEADS TO PURCHASING POWER PARITY

The law of one price is the foundation of purchasing power parity. Purchasing power parity states that the value of two currencies is equal when a basket of identical goods is priced the same in both countries. It ensures that buyers have the same purchasing power across global markets. In other words, The basis for PPP is the ''law of one price''. In the absence of transportation and other transaction costs, competitive markets will equalize the price of an identical good in two countries when the prices are expressed in te same currency.

THEORY OF PURCHASING POWER PARITY (PPP)

PPP( purchasing power parity ) is a economic theory that compares different countries' currencies through a ''basket of goods'' approach. According to this concept, two currencies are in equillibruim - known as currencies being at par - when a basket of goods is priced the same in both countries, taking into account the exchange rates.