Question

Will the law of one price apply better to gold or to Big Mac? Why?

Answer 1

The law of one price will apply better to gold than Big Mac:

• The Law of One Price says that identical goods should sell for the same price in two separate markets. This assumes no transportation costs and no differential taxes applied in the two markets.
• The law of one price constitutes the basis of the theory of purchasing power parity, an assumption that in some circumstances (for example, as a long-run tendency) it would cost exactly the same.
• For example, an ounce of gold should cost the same on commodity exchanges in Chicago and London. If the gold costs more on one exchange, then traders would have incentive to purchase the gold on one exchange and sell it at the other one. They would do what is called an arbitrage
• But the price of Big Mac is different in different countries. In fact, the Big Mac Index is an informal way of measuring the purchasing power parity ( P P P ) between two currencies and provides a test of the extent to which market exchange rates result in goods costing the same in different countries.
• Hence, while gold can be traded on exchange it is not the same for Big Mac.
• Gold being a commodity which is traded, the law of one price will apply better.