Law of One Price

LOOP is an economic theory that says that identical goods should be sold at the same price in different markets when the same currency is used, provided there are no transportation costs or trade barriers. It is central to understanding international trade, finance, and market efficiency. 

What is the Law of One Price? 

The Law of One Price asserts that the ideal market stipulates an expectation that, given exchange rates, a good or asset should have the same price in all places. This principle hinges on the idea that where such a discrepancy exists a price, arbitrage opportunities will arise that enable traders to buy low in one market and sell high in another until prices become equal. 

In essence, LOOP is founded on several underlying assumptions: 

• Free and Competitive Markets: The markets involved must be competitive, with free trade with no restrictions. 

• No Transaction Costs: No costs should be involved in transporting goods or a transaction. 

• No Trade Barriers: There must not be any tariffs, quotas, or other trade barriers to limit trade. 

• Exchange Rate Stability: The exchange rates between currencies must reflect the true value of those currencies. 

Understanding the Law of One Price 

The Law of One Price is the basis for purchasing power parity, which is the idea that two countries, other things held equal if they have the same goods baskets, should equate to one another in a common currency. This relationship has been helpful in determining whether or not currencies overvalue or undervalue others. 

Mathematically, the LOOP can be written as: 

Where: 

The price of a good in one currency; 

• is the price of the same product in another currency; 

• is the exchange rate between the two currencies 

Main Elements of LOOP 

• Same Goods: The law governs products that are identical in quality and features. Therefore, two similar smartphones should fetch a global revenue that adjusts for currency fluctuations. 

• Arbitrage: Arbitrage is the act of exploiting price differences between markets. Suppose a trader finds that a product costs US$100 in Market A and US$120 in Market B. He can buy it in Market A and sell it in Market B, which is a profit. That way, the prices get levelled off over time. 

• Market Efficiency: The law further assumes that all participants have information and would act on it without any delay. It further means that the price deviations ought to be corrected promptly through trading activities. 

Role of Technology in Enforcing LOOP 

The role of technology has been transformative in ensuring that the imposition of LOOP occurs and minimises transaction costs while at the same time achieving market efficiency. Advanced technological tools, for example, would help find and exploit price discrepancies across markets more easily and effectively, thereby promoting better price alignment. 

• Online trading platforms, including POEMS.com.sg, make online access to global financial markets easy and convenient for traders. On such a platform, it is child’s play to compare asset prices instantly between different regions, thereby executing the trade in time to capture the arbitrage opportunity. 

• Real-time data analytics-advanced algorithms and analytics using AI allow processing large market data in real-time. Traders and institutions can quickly notice the price differentials between identical or equivalent goods or securities, enabling quick action to correct the difference. 

• Blockchain Technology: Blockchain allows for a decentralised ledger system, which guarantees transparency; therefore, transactions are less susceptible to inefficiencies. The impossibility of changing immutable transaction records or removing the intermediaries makes it cheaper and easier to access while allowing reliance on the reliability of information about prices. 

• High-Frequency Trading (HFT): HFT has been possible through technology, where algorithms execute trades in milliseconds, thus removing almost the instant that arbitrage opportunities appear and, therefore, leading to faster price convergence. 

All in all, technology allows faster transactions, proper price comparisons, and better dissemination of information, thus giving room for the proper functioning of LOOP. Through bridging of geographical and informational gaps, these developments ensure that identical goods or assets are priced similarly anywhere in the world. 

Challenges and Criticisms of LOOP 

As much as the Law of One Price is appealing as a theoretical concept, it is very much associated with challenges and criticisms: 

• Transaction Costs: Pragmatically, most activities involving buying and selling comprise transportation, taxes, and tariffs. Such costs greatly reduce arbitrage opportunities. 

• Market Segmentation: Markets may differ through degrees of competition, consumer preferences, and the regulatory environment. For example, luxury goods might be priced more highly in wealthy areas because of demand elasticity. 

• Currency Fluctuations: Exchange rates can be very volatile, depending on economic conditions and, hence, the relative pricing of commodities across countries. If a currency depreciates significantly, it will lead to higher local prices even if the international price does not rise. 

• Quality Differences: Although apparently identical goods, differences in local laws or manufacturing standards may mean slightly different items are sold in different regions. An example is electronic goods sold in distinct regions, which differ on specifications or warranty conditions. 

These factors lead to those instances where LOOP cannot hold and continue price differences among markets. 

Case Studies and Examples of LOOP in Practice  

The Law of One Price can be experienced with several real-life examples: The Big Mac Index. 

One famous example is the Big Mac Index by The Economist, which is an attempt to have fun while calculating the ‘purchasing power parity’ between two currencies. The index lists the price of a Big  

Mac hamburger in different countries: 

• According to LOOP, if the same hamburger costs US$5 in the United States and £4 in the United Kingdom, the exchange rate should be US$1.25/GBP. 

• If actual exchange rates are greatly different from this value, it implies that one currency may be undervalued or overvalued relative to another. 

• This index is both an educational tool and a practical measure for assessing the valuation of currencies based on consumer goods. 

Arbitrage Opportunities in Financial Markets 

LOOP appears within financial markets as arbitrage opportunities amongst securities: 

• Consider the same two equivalent stocks trading on two different exchanges. If Stock A is bought on Exchange 1 for US$50 but sold on Exchange 2 for US$55, an arbitrageur could buy it on one exchange and sell it on the other for a profit of US$5 per share. 

• Disparities like this exist only briefly as some traders will jump on them quickly, making this firmly part of the belief that equivalent securities should be priced the same on all markets. 

Purchasing Power Parity 

The theory does not stop at individual products. Take, for example, a basket of goods with a price of US$100 in the US but SGX 120 in Singapore, adjusted for differences in exchange rates. This price difference may suggest an overvaluation of the Singapore dollar compared to the US dollar. 

Frequently Asked Questions