Assumptions of Law of One Price

Law of one price states that, in equilibrium conditions the price of a commodity will be same all over the world, because if it is not then arbitrageurs will drive the price towards equilibrium by buying in the cheaper market and selling in dearer market. However it is based on certain assumptions which are as follows –

1. The law of one price assumes that there is no restriction on the movement of goods implying that there is no curb by any country in the form of ban as well as quota on exports and imports and international trade can take place between various countries.

2. It also assumes there is no tariff imposed by the countries, also there are no transaction costs associated with buying and selling of goods in various countries.

3. It also assumes the absence of transportation costs which are associated with the export and import of goods in order to be law of one price to be valid.

As can be seen that above assumption in real world seldom happens because transportation costs are always there and also some country do not allow international trade to happen with other countries due to political reasons. However this theory still holds importance and it lays the foundation for determination of exchange rates of various countries.

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