The Law of One Price & Purchasing Power Parity

0
26
The Law of One Price & Purchasing Power Parity

The economy is a very wide branch that includes many important elements, strategies, theories, and definitions. One of them is the law of one price. This kind of theory is responsible for explaining why prices of assets, securities, and commodities are the same in different markets regardless of their exchange rates. In efficient markets, the law of one price is a dominating one. The result of a correct law of one price is called a purchasing power parity. It means that buyers have got equal power concerning other buyers because the price is the same regardless of the market.

The law of one price – what is it?

The conception of the law of one price seems complicated, but in fact, it is very simple and easy to understand. According to this law, the price of an asset, commodity or security will be the same across different markets and different countries according to exchange rates. This rule is very important, because if the price of an asset is cheaper in one of the markets, then investors will buy it and sell it in a more expensive market to get profits. This situation is called market arbitrage. Of course, this situation will not last forever, because more and more investors will be interested in the cheaper market, so demand and supply will change until the price reaches a balanced level across all the markets.

We need to remember that some factors affect prices in various markets. These factors are taxes, tariffs or transportation costs. That is why customers have to pay different prices in different markets. We can find some products (groceries or gas) that will be more expensive on islands, because of the necessity of transportation through the sea or air, but the base price will be similar to other markets according to the law of one price.

For example, Market A is selling products for €100 and Market B is selling the same products for €10. Investors will be interested in buying Market B products and sell them to Market A, because of the higher price. Of course, this situation will not last forever, because if more investors start selling to Market A, than the competition will be much higher and the prices will decrease. Thanks to the law of one price, these prices will be balanced across all the markets. It is a very important law that makes the market balanced, more efficient and fair.

The theory of purchasing power parity

The aforementioned law generates a result that is called the purchasing power parity. If the law of one price works appropriately then buyers will have the same purchasing power in all markets, regardless of the exchange rate of currencies. Thanks to this, markets will be fair and customers have got better access to different products, assets, etc. Of course, it can be difficult to achieve purchasing power parity on all the markets, because of many reasons.

As we can see the law of one price is very important to the world’s economy, customers and investors. That is why we can observe it in many international markets.

LEAVE A REPLY

Please enter your comment!
Please enter your name here