The law of one price states that in the absence of trade frictions, and under conditions of free competition and price flexibility, identical goods sold in different locations must sell for the same price when prices are expressed in a common currency. This law is derived from the assumption of the inevitable elimination of all arbitrage.
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.
Example 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.
can be traded on financial markets, where there will be a single offer price, and bid price. Although there is a small spread between these two values the law of one price applies. No trader will sell the commodity at a lower price than the market maker'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 instruments which appear different, but which resolve to the same set of cash flows; see Rational pricing. Thus: A similar argument can be used by considering arrow securities as alluded to by Arrow and Debreu.
Non-application
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 market maker's prices are continually moving inliquid markets. However, at the moment each trade is executed, the law is in force.
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 and a low price.
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 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.
Prerequisite
absence of trade frictions
under free competition
under price flexibility
The law of one price has been applied towards the analysis of many public events, such as:
In 2015, An International Monetary Fundworking paper found that the law of one price holds for most tradeable products in Brazil but does not apply in the same way to its non-tradeable goods.
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 stocks. After merging in 1907, holders of Royal Dutch Petroleum and Shell Transport shares 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.
