Law of one price
Encyclopedia
The law of one price is an economic law stated as: "In an efficient market, all identical goods
must have only one price."
will flock to the highest prevailing price, and all buyers
to the lowest current market price. In an efficient market the convergence on one price is instant. For discussion see further under Rational pricing
.
price (asking price), and bid
price. Although there is a small spread
between these two values the law of one price applies (to each). No trader will sell
the commodity at a lower price than the market maker
's offer-level or buy
at a higher price than the market maker's bid-level. In either case moving away from the prevailing price would either leave no takers, or be charity
.
In the derivatives
market the law applies to financial instruments which appear different, but which resolve to the same set of cash flows; see Rational pricing
. Thus:
Product (business)
In general, the product is defined as a "thing produced by labor or effort" or the "result of an act or a process", and stems from the verb produce, from the Latin prōdūce ' lead or bring forth'. Since 1575, the word "product" has referred to anything produced...
must have only one price."
Intuition
The intuition for this law is that all sellersSupply (economics)
In economics, supply is the amount of some product producers are willing and able to sell at a given price all other factors being held constant. Usually, supply is plotted as a supply curve showing the relationship of price to the amount of product businesses are willing to sell.In economics the...
will flock to the highest prevailing price, and all buyers
Demand (economics)
In economics, demand is the desire to own anything, the ability to pay for it, and the willingness to pay . The term demand signifies the ability or the willingness to buy a particular commodity at a given point of time....
to the lowest current market price. In an efficient market the convergence on one price is instant. For discussion see further under Rational pricing
Rational pricing
Rational pricing is the assumption in financial economics that asset prices will reflect the arbitrage-free price of the asset as any deviation from this price will be "arbitraged away"...
.
An example: Financial markets
Commodities can be traded on financial markets, where there will be a single offerDiscounts and allowances
Discounts and allowances are reductions to a basic price of goods or services.They can occur anywhere in the distribution channel, modifying either the manufacturer's list price , the retail price , or the list price Discounts and allowances are reductions to a basic price of goods or services.They...
price (asking price), and bid
BID
Bid may refer to:*Bidding, making a price offer in an auction, stock exchange, or card games*Bid , a British home shopping channel...
price. Although there is a small spread
Spread
Spread may refer to:*Statistical dispersion*Spread , an edible paste put on other foods*the score difference being wagered on in spread betting*the measure of line inclination in rational trigonometry...
between these two values the law of one price applies (to each). No trader will sell
Sell
Sell can refer to:*A verb relating to sales*Sell *One of several people named Edward Sell *Mary Elizabeth Sell, New York City Ballet dancer*Friedrich L...
the commodity at a lower price than the market maker
Market maker
A market maker is a company, or an individual, that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on the bid-offer spread, or turn. From a market microstructure theory standpoint, market makers are net sellers of an option to be...
's offer-level or buy
Trade
Trade is the transfer of ownership of goods and services from one person or entity to another. Trade is sometimes loosely called commerce or financial transaction or barter. A network that allows trade is called a market. The original form of trade was barter, the direct exchange of goods and...
at a higher price than the market maker's bid-level. In either case moving away from the prevailing price would either leave no takers, or be charity
Gift
A gift or a present is the transfer of something without the expectation of receiving something in return. Although gift-giving might involve an expectation of reciprocity, a gift is meant to be free. In many human societies, the act of mutually exchanging money, goods, etc. may contribute to...
.
In the derivatives
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
market the law applies to financial instruments which appear different, but which resolve to the same set of cash flows; see Rational pricing
Rational pricing
Rational pricing is the assumption in financial economics that asset prices will reflect the arbitrage-free price of the asset as any deviation from this price will be "arbitraged away"...
. Thus:
- "a security must have a single price, no matter how that security is created. For example, if an option can be created using two different sets of underlying securities, then the total price for each would be the same or else an arbitrageArbitrageIn economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
opportunity would exist." A similar argument can be used by considering arrow securitiesState pricesIn financial economics, a state-price security, also called an Arrow-Debreu security , is a contract that agrees to pay one unit of a numeraire if a particular state occurs at a particular time in the future and pay zero numeraire in all other states...
as alluded to by Arrow and Debreu (1944).
Where the law does not apply
- The law does not apply intertemporally, so prices for the same item can be different at different times in one market. The application of the law to financial markets in the example above is obscured by the fact that the market makerMarket makerA market maker is a company, or an individual, that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on the bid-offer spread, or turn. From a market microstructure theory standpoint, market makers are net sellers of an option to be...
's prices are continually moving in liquidMarket liquidityIn business, economics or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value...
markets. However, at the moment each trade is executed, the law is in force (it would normally be against exchange rules to break it). - The law also need not apply if buyers have less than perfect information about where to find the lowest price. In this case, sellers face a tradeoff between the frequency and the profitability of their sales. That is, firms may be indifferent between posting a high price (thus selling infrequently, because most consumers will searchSearch theoryIn microeconomics, search theory studies buyers or sellers who cannot instantly find a trading partner, and must therefore search for a partner prior to transacting....
for a lower one) and a low price (at which they will sell more often, but earn less profit per sale). - The Balassa-Samuelson effect argues that the law of one price is not applicable to all goods internationally, because some goods are not tradableTradableTradability is the property of a good or service that can be sold in another location distant from where it was produced. A good that is not tradable is called non-tradable. Different goods have differing levels of tradability: the higher the cost of transportation and the shorter the shelf life,...
. It argues that the consumption may be cheaper in some countries than others, because nontradables (especially land and labor) are cheaper in less developed countries. This can make a typical consumption basket cheaper in a less developed country, even if some goods in that basket have their prices equalized by international trade.
Apparent violations
- A well-known example of an apparent violation of the law was Royal DutchRoyal Dutch ShellRoyal Dutch Shell plc , commonly known as Shell, is a global oil and gas company headquartered in The Hague, Netherlands and with its registered office in London, United Kingdom. It is the fifth-largest company in the world according to a composite measure by Forbes magazine and one of the six...
/ShellShell Oil CompanyShell Oil Company is the United States-based subsidiary of Royal Dutch Shell, a multinational oil company of Anglo Dutch origins, which is amongst the largest oil companies in the world. Approximately 22,000 Shell employees are based in the U.S. The head office in the U.S. is in Houston, Texas...
shares. After merging in 1907, holders of Royal Dutch Petroleum (traded in Amsterdam) and Shell Transport shares (traded in London) were entitled to 60% and 40% respectively of all future profits. Royal Dutch shares should therefore automatically have been priced at 50% more than Shell shares. However, they diverged from this by up to 15%. This discrepancy disappeared with their final merger in 2005.