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The Law of One Price (LOOP) is an economic principle stating that identical goods should cost the same across different markets when external factors like transportation and trade barriers are absent. It relies on assumptions such as perfect competition and stable exchange rates. The concept is crucial in understanding market efficiency, international trade, and the role of arbitrage in maintaining price parity. While ideal conditions are rare, LOOP is a key theoretical tool for analyzing pricing dynamics and market equilibrium.
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The Law of One Price states that in an efficient market, identical goods should have the same price in different markets when converted into a common currency
Perfectly Competitive Markets
The Law of One Price assumes that markets are perfectly competitive, with many buyers and sellers and no barriers to entry
Absence of Transportation and Transaction Costs
The Law of One Price assumes that there are no costs associated with transporting goods between markets or conducting transactions
Stable Exchange Rates
The Law of One Price assumes that exchange rates accurately reflect the purchasing power parity between currencies
The assumptions of the Law of One Price are essential for understanding its theoretical foundations and implications for economic models
The Law of One Price has implications for international trade and finance, as it suggests that identical goods should have the same price globally
The global oil market often adheres to the Law of One Price, with consistent prices for oil worldwide
The Big Mac Index, which uses the price of a Big Mac in different countries to evaluate currency valuation, is a lighthearted illustration of the Law of One Price
The Law of One Price dictates that bonds with equivalent risk and return profiles should have the same price across different markets
Arbitrage is the cornerstone of the Law of One Price, exploiting price discrepancies to achieve market equilibrium
Real-world market imperfections, such as regulatory constraints and limited market access, can result in deviations from the Law of One Price
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LOOP Market Conditions
Requires efficient markets, no transport costs, no trade barriers.
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Arbitrage Role in LOOP
Exploits price differences across markets to enforce price uniformity.
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LOOP Assumption on Currency
Prices compared after converting to a common currency.
