Law of One Price

The law of one price states that identical goods or assets should sell for the same price across different markets once currency differences and transaction costs are accounted for. Under ideal conditions—no trade barriers, no transaction or transportation costs, and free market entry—price differences create arbitrage opportunities that push markets toward a single price.

How it works

• If the same asset sells for different prices in two markets, traders buy in the cheaper market and sell in the more expensive one.
• This arbitrage increases demand (and price) where the asset is cheap and increases supply (and lowers price) where it is expensive, moving prices toward parity.
• The concept underpins purchasing power parity (PPP), which compares currency values by asking whether a basket of identical goods costs the same across countries.

Real-world applications

• Arbitrage: Traders exploit price gaps in commodities, securities, or goods until price differences narrow or disappear.
• Purchasing Power Parity: Economists use PPP to assess whether currencies are under- or overvalued based on the price of a common basket of goods.
• Big Mac Index: An informal measure comparing the price of a McDonald’s Big Mac across countries to illustrate how trade frictions and local costs affect price parity.

Key assumptions

• No transaction or transportation costs.
• No tariffs, capital controls, or legal restrictions on trade.
• Free entry and competition among market participants.
• Uniform and accessible exchange rates when comparing across currencies.

Why the law often fails in practice

• Transportation costs: Physical goods incur shipping costs that create price differentials between regions.
• Transaction costs: Search, negotiation, enforcement, and other costs can prevent profitable arbitrage.
• Legal and policy barriers: Tariffs, quotas, immigration restrictions, and capital controls sustain price differences.
• Market structure and pricing power: Monopolies, oligopolies, and varying market concentration can result in different prices for the same good.
• Local factors: Labor costs, taxes, regulations, and preferences lead to persistent price variation even for similar products.

Implications for finance

In financial markets, the law implies equivalent securities (including synthetics) should trade at the same price. If not, arbitrageurs can construct riskless strategies to profit until prices align. Real-world frictions—such as differing regulations, settlement costs, or liquidity—can prevent perfect alignment.

Key takeaways

• The law of one price is a theoretical benchmark: identical goods should cost the same across markets absent frictions.
• Arbitrage drives prices toward parity but is limited by transportation, transaction costs, and legal barriers.
• The principle underlies purchasing power parity and tools like the Big Mac Index, highlighting currency and market influences on prices.
• Understanding its assumptions and limitations helps interpret cross-market price differences and currency valuations.

Conclusion

The law of one price provides a useful framework for thinking about price alignment and arbitrage across markets. While valuable in theory and in many financial pricing arguments, real-world frictions mean perfect price equality is rarely achieved. Appreciating both the mechanism and the common exceptions improves decision-making for investors, traders, and policymakers.