Under what conditions could the law of one price be violated?

Question

What will be an ideal response?

Answer 1

Answer: The law of one price says that the price of a good, when denominated in a particular currency, is the same wherever in the world the good is being sold. The law of one price relies on arbitrage in the goods market. If the good is being sold in one place at a low price and is being sold in a different place at a high price, people have an incentive to arbitrage the two markets. Therefore, anything that makes it difficult or costly to arbitrage in the goods market can create a deviation from the law of one price. Clearly, transaction costs, such as the costs of shipping, generate deviations from the law of one price that cannot be arbitraged. Tariffs and quotas on imports and exports also create deviations. If markets are not competitive and firms have some monopoly power, the corporation may decide to charge different prices in different countries, but it must be able to segment the markets to prevent arbitrage. If arbitrage cannot be done instantaneously, there will be a speculative element that enters the calculations and the speculator may have to be compensated for the risk of loss with an expected profit from buying in one market and selling in another market at a later point in time. Finally, various goods markets are subject to a certain amount of price stickiness because of the costs of changing prices. Because exchange rates are asset prices and freely flexible, unanticipated changes in exchange rates will create deviations from the law of one price if goods prices are sticky.