Law of one price

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The law of one price states that in an efficient market, identical goods have equal prices. A more approximate form of this law states that if identical or very similar goods have vastly differing prices, their prices will converge towards the same price: in other words, the more expensive good will tend to fall in price and the less expensive good will tend to rise in price til lthe prices are equal.

The law of one price has the following forms:

  • Across borders, the same price in different markets that can trade freely: This states that if transaction costs between markets are sufficiently low, and there are no trade barriers, then the prices of identical goods in different markets tend to be equal. If the prices are not equal, then this creates an opportunity for arbitrage, which in turn tends to push the prices towards equality.
  • Across time: The law of one price also tends to make prices more uniform over time, if goods can be traded and risks can be hedged.

The extent to which the law of one price fails to hold is measured by price dispersion.