Law of One Price (Essay Sample)
The Law of One Price states that equivalent investment opportunities trading in different competitive markets will have the same price. Yet, one can find examples where that rule seems to be violated. It is a well-known fact that Americans pay a much higher price for most prescription drugs than people in most other countries. Also, the price (when adjusted for exchange rates) for the same make and model of automobile varies greatly across different countries. Furthermore, the price of a barrel of crude oil varies between locations. For example, on October 12, 2012, the price for Brent crude oil produced in Europe was $114.21 and the price for West Texas Intermediate (WTI) crude oil produced in Texas was $91.86.
In answering the above question, discuss the Law of One Price and discuss what would happen if a good is trading at different prices in different markets.
Law of One Price
Law of One Price
The law of one price states that the price of any given, security, product, or asset need to have the same price once the exchange rates are taken into consideration. This theory ensures that the notion of purchasing power parity is maintained as derived from the concept of no arbitrage hypothesis. The idea of this law is the assumption that any differences between pricing get eliminated by market members that may take advantage of the arbitrage prospects. In essence, if a possibility can be developed using unique sets of fundamental securities, ultimately, the total price for each one of them has to be the same (Harris, 2008).
When a product is trading at a differing price in different markets, the law of one price ensures that a balance is warranted. For example, assume that there is a specific, identical product in two localities with no transport cost and no economic hindrances in both areas. The arbitrage ideology can be conducted using both the supply and demand factors. Here, all sellers have the chance to sell their products in the higher-priced locality, and this increases the supply in this region, and lowers supply in a lower-priced area. If the demand stays constant, increased supply forces the prices down in the higher-priced area, and the decreased supply in the alternate locality will push the prices up. Equally, if consumers flood the lower-price area to get the product at a low price, the demand will go up in the lower-priced area. Additionally, constant supply in both areas mean prices will have to increase and lowered demand in the higher-priced area will result in lowered prices. In both scenarios, there is a single and equal price per every similar product in al...
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