‘In the assumed absence of transport costs and trade restrictions, perfect commodity arbitrage insures that each good is uniformly priced (in common currency units) throughout the world – the “law of...

“LAW OF ONE PRICE” & “THEORY OF PURCHASING POWER PARITY”
- A CRITICAL ANALYSIS
“LAW OF ONE PRICE” & “THEORY OF PURCHASING POWER PARITY”
(A CRITICAL ANALYSIS)
“LAW OF ONE PRICE” & “THEORY OF PURCHASING POWER PARITY”
- A CRITICAL ANALYSIS
INTRODUCTION
The PURCHASING POWER PARITY theory was introduced in the Seventeenth century,
whereas the economist most credited with the growth of the theory of P.P.P is Karl Gustav
Cassel (1921). His work then on exchanges rates was the central idea behind this theory. The
asic concept of the L.O.P forms the foundation of the P.P.P hypothesis, and states that after
converting into common cu
ency, identical goods of various companies should trade at one
price:
nn EPP *
where nP is the local cu
ency price of a good, E (actual nominal exchange rate) is the local
cu
ency price of the foreign cu
ency and nP* is the foreign cu
ency price of a good.
The key process that is responsible for the convergence of prices is a
itrage. A
itrage is the
process of buying or selling a good in order to exploit a price differential so as to make a risk-
less profit. Once the process starts, it continues until prices have converged to the extent that no
more profit can be made.
The law of one price theory can applied to both an intra-country and an international setting; all
that is required is conversion to a common cu
ency. The theory does somewhat abstract from
eality, since in practice crossing a border does affect pricing. Cu
ently, there are still numerous
aspects of international trade that have an impact on country specific prices. Transport costs,
tariffs and other non-tariff ba
iers influence prices and last two distort the prices that are be paid
for goods. We need to account for these distortions when working with international prices. The
main principle however does not change and price equalization should occur through a
itrage
and a greater degree of free trade.
“LAW OF ONE PRICE” & “THEORY OF PURCHASING POWER PARITY”
- A CRITICAL ANALYSIS
The basic concept of PURCHASING POWER PARITY is the "law of one price". When two goods
are expressed in one cu
ency, then two goods will have same price, when expressed in same
cu
ency in the absence of various costs Eg: transportation costs, taxes, transaction costs etc.
Example, a particular Generator set that is selling for 2250 Canadian Dollars [CAD] in Ontario
would cost 1500 US Dollars [USD] in Philippines when the cu
ency rate of exchange between
Canada and US is 1.55 CAD/USD. If the price of the Generator Set in Ontario was only 2100 CAD,
consumers in Philippines will prefer buying the Generator set in Ontario. If the process (called
"a
itrage") is being ca
ied out on a huge scale, the US consumers who are buying Canadian goods
would bid for the value of the Canadian Dollar, hence making Canadian goods comparatively more
costly to them. The process continues till the goods have the same price. There are three bases with
this law of one price. (1)Transporting costs, Ba
iers in trade, and various other transactions costs,
can also be significant. (2) Competitive markets for both the countries. (3) The law of one price only
applies to trading goods; fixed goods such as houses, and various services that cannot be transfe
ed.
An economist uses following versions of Purchasing Power Parity:
(1)Absolute PPP
It basically refers to the equity of price levels among countries. Put directly, the exchange
ate between United States and the Canada EUSD/CAD equals to the price level in United
States PUSA divided by the price level in the Canada PCAD. Assuming the level of price
atio PUSD/PCAD implies an exchange rate of 1.3 USD per 1 CAD. If today's exchange rate
EUSD/CAD is 1.5 USD per 1 CAD, PURCHASING POWER PARITY theory implies that
the USD will appreciate (get stronger) against the CAD, and the CAD will in turn
depreciate (get weaker) against the USD.
“LAW OF ONE PRICE” & “THEORY OF PURCHASING POWER PARITY”
- A CRITICAL ANALYSIS
(2)Relative PPP.
Relative PPP basically relates to inflation rates, i.e. the rates of change. The explanation states
that the rate of appreciation in a cu
ency equates to the difference in inflation rates between the
home and the foreign country. For example, if United States has an inflation rate of 1% and the
Canada has an inflation rate of 3%, the Canadian Dollar will depreciate against the United
States Dollar by 2% per year. This proposition will hold well...