Law Of One Price

Published Oct 25, 2023

Definition of the Law of One Price

The Law of One Price states that in competitive markets, identical goods should have the same price when expressed in a common currency. This principle is based on the assumption that there are no restrictions on trade, transportation costs, or other barriers that would prevent price equalization across different locations.

Example

To illustrate the Law of One Price, let’s consider a simple scenario involving a commodity like wheat. Suppose there are two countries, A and B, and both produce and consume wheat. In a perfectly competitive market, the price of wheat in country A should be the same as the price in country B. If the price in country A is higher, importers from country B will have an incentive to buy wheat from country A and sell it in their own country, which would increase supply and reduce the price in country A. Conversely, if the price in country B is higher, exporters from country A will have an incentive to sell their wheat in country B, which would increase demand and raise the price in country B. Over time, these actions would lead to price convergence and the elimination of any price differences between the two countries.

However, it is important to note that deviations from the Law of One Price can occur due to factors like transportation costs, trade restrictions, currency exchange rates, tariffs, and non-tariff barriers. These factors can create price differentials between markets, even for identical goods.

Why the Law of One Price Matters

The Law of One Price is an essential concept in international trade and finance. It helps to guide economic analysis and policy decisions related to trade flows, exchange rates, and market integration. Deviations from the Law of One Price can indicate market inefficiencies and barriers to trade, which can have implications for resource allocation, competition, and welfare. Understanding and promoting price equalization can lead to more efficient markets and expanded economic opportunities for countries and consumers.