3. The law of one price
Which of the following correctly states the law of one price?
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The law of one price asserts that in the long run, exchange rates will adjust so that the purchasing power of a unit of currency is the same whether it is spent domestically or converted into another currency and spent abroad. According to the law of one price, the same good being sold for different prices in different areas creates conditions that bring about the equalization of prices. Specifically, the difference in prices creates an opportunity for individuals to profit by buying the good in the low-price area in order to sell it in the high-price area. However, the resulting increase in demand in the low-price area puts upward pressure on prices there, and the increase in supply in the high-price area puts downward pressure on prices there. This process continues until the prices in the two areas equalize, leaving no opportunity to profit by buying in one area and selling in another.
The law of one price, therefore, predicts that—with no restrictions on trade and zero transportation costs—the cost of individual goods or a general bundle of goods and services should be about the same, regardless of where they are sold.
Which of the following scenarios illustrates why the law of one price may not hold? Check all that apply.
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The law of one price is built on the assumption that there are no restrictions on the trade of goods and services and that transportation costs are low. Therefore, the law of one price may not hold in cases where the transportation costs are high, the goods cannot be transported, or there exist trade tariffs and quotas.
For example, because fresh tropical fruits require special treatment during transportation to maintain their freshness, transportation costs will be higher. The law of one price is less likely to hold for these types of goods than for nonperishable goods.
On the other hand, the transportation of light goods such as small electronic devices will be relatively cheap. The law of one price is more likely to hold for these types of goods than for heavy goods.
The formation of the European Union removes the trade barriers between its member states. This will lower the transportation costs of goods and services among the member states. Therefore, the law of one price is more likely to hold in this case.