Answer to Question #99839 in Macroeconomics for Tiffany

Question

4. Purchasing power parity and the law of one price are two related concepts.
a. Explain what is meant by the law of one price. Also explain why a person or nation could profit if this law does not hold.
b. Offer three reasons why the law of one price might not hold for some goods.
c. Explain what is meant by purchasing power parity. Also explain how purchasing power parity relates to the law of one price.

Answer 1

A. The law of one price is the economic theory that states that the price of an identical security, commodity or asset traded anywhere should have the same price regardless of location when currency rates are taken into consideration ,if it is traded in a free market with no trade restrictions.to earn profit, an arbitrageur will purchase the asset in the cheaper market and sell it in market where prices are higher.

B. The law of one price states that prices of the same good will be identical in different markets countries. However, a requirement for this to occur is for goods to be traded so that arbritage conditions exist. Goods that cannot be traded cannot take advantage of arbritage conditions and therefore are unlikely to converge the same price. Even goods that are identical may not converge to the same price because of the local nontraded input price differences like labour, rent and transportation

C. Purchasing power parity is a theory that says that in the long run, the exchange rates between countries should even out so that goods essentially cost the same in both counties. Purchasing power parity is based on the law of one price which implies that all identical goods should have the same price.