Introduction
The Law Of One Price (referred to as LOOP) is an economic theory which states that the price of identical goods in various markets must be the same after taking into consideration the currency exchange, i.e. when the prices are expressed in the same currency. The law applies mainly to securities traded on financial markets.
LOOP forms the basis of the purchasing power parity principle. The assertion, in some cases, would cost exactly the same number. For example, US dollars required to buy euros and then use the proceeds to buy a basket of goods will be the same if those dollars are directly used for the purchase of the basket.
Understanding the Law
The law is based on few principles, which include free-market competition, the lack of trade restrictions, and price stability (neither sellers nor buyers can control the prices of the products, and prices are freely adjusted). The one price law generally refers to a wide array of products, securities, and properties.
The LOOP primarily persists due to incentives for arbitration. If the prices of similar products diverge across the markets, arbitration opportunities arise as a trader may buy a product at a lower price in a market and sell it at a higher price for a net profit instantly in another market.
Economic theory notes that eventually, supply and demand mechanisms would converge prices across economies, thereby reducing arbitration incentives.
However, in reality, the law of one price does not always hold true. Say, if the trade of goods involves transaction costs or trade barriers, the law will not work.
Prerequisites of Law of One Price
The following are the prerequisites for the Law Of One Price:
- Absence of trade frictions
- Under free competition
- Under price flexibility
