Anomalies: The Law of One Price in Financial Markets

Anomalies: The Law of One Price in Financial Markets

Anomalies: The Law of One Price in Financial Markets: It is good for a scientific enterprise, as well as for a society, to have well-established laws. Physics has excellent laws, such as the law of gravity. What does economics have? The first law of economics is clearly the law of supply and demand,and a fine law it is. We would nominate as the second law “the law of one price,”hereafter simply the Law. The Law states that identical goods must have identical prices. For example, an ounce of gold should have the same price (expressed in U.S. dollars) in London as it does in Zurich, otherwise gold would flow from one city to the other. Economic theory teaches us to expect the Law to hold exactly in competitive markets with no transactions costs and no barriers to trade, but in practice, details about market institutions are important in determining whether violations of the Law can occur.

Anomalies: The Law of One Price in Financial Markets Introduction

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Consider the case of aspirin. Suppose, for the sake of argument, that Bayer aspirin and store brand aspirin are identical products, but that Bayer costs twice as much because some consumers believe (falsely, in this example) that Bayer is better. Would we expect markets to eradicate this price difference? Since the Bayer brand name is trademarked, it is not (legally) possible to go into the business of buying the store brand aspirin and repackaging it in Bayer bottles. This inability to transform the store brand into Bayer prevents one method arbitrageurs might use to drive the two prices to equality. Another possibility for arbitrageurs would be to try to sell the more expensive Bayer aspirin short today, betting that the price discrepancy will narrow once the buyers of Bayer “come to their senses.” Short selling works like this: an arbitrageur would borrow some bottles from a cooperative owner, sell the bottles today and promise the owner to replace the borrowed bottles with equivalent Bayer bottles in the future. Notice that two problems impede this strategy. First, there is no practical way to sell a consumer product short, and second, there is no way to predict when consumers will see the error in their ways.These problems create limits to the forces of arbitrage, and in most consumer goods markets, the Law may be violated quite dramatically.

Law of One Price

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