economics Economics () is a behavioral science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services. Economics focuses on the behaviour and interac ...

, the law of one price (LOOP) states that in the absence of

trade Trade involves the transfer of goods and services from one person or entity to another, often in exchange for money. Economists refer to a system or network that allows trade as a market. Traders generally negotiate through a medium of cr ...

frictions (such as transport costs and

tariff A tariff or import tax is a duty (tax), duty imposed by a national Government, government, customs territory, or supranational union on imports of goods and is paid by the importer. Exceptionally, an export tax may be levied on exports of goods ...

s), and under conditions of free competition and price flexibility (where no individual sellers or buyers have power to manipulate prices and prices can freely adjust), identical

goods In economics, goods are anything that is good, usually in the sense that it provides welfare or utility to someone. Alan V. Deardorff, 2006. ''Terms Of Trade: Glossary of International Economics'', World Scientific. Online version: Deardorffs ...

sold at different locations should be sold for the same price when prices are expressed in a common

currency A currency is a standardization of money in any form, in use or circulation as a medium of exchange, for example banknotes and coins. A more general definition is that a currency is a ''system of money'' in common use within a specific envi ...

. This law is derived from the assumption of the inevitable elimination of all

arbitrage Arbitrage (, ) is the practice of taking advantage of a difference in prices in two or more marketsstriking a combination of matching deals to capitalize on the difference, the profit being the difference between the market prices at which th ...

. See .

Overview

The intuition behind the law of one price is based on the assumption that differences between prices are eliminated by market participants taking advantage of arbitrage opportunities. There are three pre-requisites underlying the law: *Absence of trade frictions *Free competition *Price flexibility.

Examples

In regular trade

Assume different prices for a single identical good in two locations, no transport costs, and no economic barriers between the two locations. Arbitrage by both buyers and sellers can then operate: buyers from the expensive area can buy in the cheap area, and sellers in the cheap area can sell in the expensive area. Both scenarios result in a single, equal price per homogeneous good in all locations. ''For further discussion, see Rational pricing''.

In formal financial markets

Commodities In economics, a commodity is an economic good, usually a resource, that specifically has full or substantial fungibility: that is, the market treats instances of the good as equivalent or nearly so with no regard to who produced them. Th ...

can be traded on financial markets, where there will be a single offer price (asking price), and bid price. Although there is a small spread between these two values the law of one price applies (to each). No trader will sell the commodity at a lower price than the

market maker A market maker or liquidity provider is a company or an individual that quotes both a buy and a sell price in a tradable asset held in inventory, hoping to make a profit on the difference, which is called the ''bid–ask spread'' or ''turn.'' Thi ...

's bid-level or buy at a higher price than the market maker's offer-level. In either case moving away from the prevailing price would either leave no takers, or be charity. In the derivatives market the law applies to

financial instrument Financial instruments are monetary contracts between parties. They can be created, traded, modified and settled. They can be cash (currency), evidence of an ownership, interest in an entity or a contractual right to receive or deliver in the form ...

s which appear different, but which resolve to the same set of cash flows; see Rational pricing. Thus:''''

A security must have a single price, no matter how that security is created. For example, if an option can be created using two different sets of underlying securities, then the total price for each would be the same or else an arbitrage opportunity would exist.

A similar argument can be used by considering arrow securities as alluded to by Arrow and Debreu (1944).

Aspects of non-applicability

The law does not apply ''intertemporally'', so prices for the same item can be different at different times in one market. The application of the law to financial markets is obscured by the fact that the

's prices are continually moving in

liquid Liquid is a state of matter with a definite volume but no fixed shape. Liquids adapt to the shape of their container and are nearly incompressible, maintaining their volume even under pressure. The density of a liquid is usually close to th ...

markets. However, at the ''moment'' each trade is executed, the law is in force (it would normally be against exchange rules to break it). The law also need not apply if buyers have less than perfect information about where to find the lowest price. In this case, sellers face a tradeoff between the frequency and the profitability of their sales. That is, firms may be indifferent between posting a high price (thus selling infrequently, because most consumers will search for a lower one) and a low price (at which they will sell more often, but earn less profit per sale). The Balassa–Samuelson effect argues that the law of one price is not applicable to all goods internationally, because some goods are not tradable. It argues that the consumption may be cheaper in some countries than others, because nontradables (especially land and labor) are cheaper in less-developed countries. This can make a typical consumption basket cheaper in a less-developed country, even if some goods in that basket have their prices equalized by international trade.

Applications

The law of one price has been applied towards the analysis of many public events, such as: *In 2015, an

International Monetary Fund The International Monetary Fund (IMF) is a major financial agency of the United Nations, and an international financial institution funded by 191 member countries, with headquarters in Washington, D.C. It is regarded as the global lender of las ...

working paper found that the law of one price holds for most tradeable products in

Brazil Brazil, officially the Federative Republic of Brazil, is the largest country in South America. It is the world's List of countries and dependencies by area, fifth-largest country by area and the List of countries and dependencies by population ...

but does not apply in the same way to its non-tradeable goods. *A director of the Council on Foreign Relations held in 2013 that the then-current

Apple An apple is a round, edible fruit produced by an apple tree (''Malus'' spp.). Fruit trees of the orchard or domestic apple (''Malus domestica''), the most widely grown in the genus, are agriculture, cultivated worldwide. The tree originated ...

iPad mini followed the law of one price, as far as its price nearly reached the same US dollar

exchange rate In finance, an exchange rate is the rate at which one currency will be exchanged for another currency. Currencies are most commonly national currencies, but may be sub-national as in the case of Hong Kong or supra-national as in the case of ...

in each applicable country. *Indonesian governmental oil subsidies against oil smugglers; The smugglers selling stolen government-discounted oil back to its market rate. *An apparent violation of the law involving international Royal Dutch/

Shell Shell may refer to: Architecture and design * Shell (structure), a thin structure ** Concrete shell, a thin shell of concrete, usually with no interior columns or exterior buttresses Science Biology * Seashell, a hard outer layer of a marine ani ...

stocks. After merging in 1907, holders of Royal Dutch Petroleum (traded in Amsterdam) and Shell Transport shares (traded in London) were entitled to 60% and 40% respectively of all future profits. Royal Dutch shares should therefore automatically have been priced at 50% more than Shell shares. However, they diverged from this by up to 15%. This discrepancy disappeared with their final merger in 2005. In recent years the company has had two different shares, "A" and "B" shares. Although each carries the same rights to dividends etc, they usually trade at different prices. This can be explained by different tax treatments.

Overview

Examples

In regular trade

In formal financial markets

Aspects of non-applicability

Applications

See also

References

Further reading