The Law of One Price is a rule that states that in an efficient market, a security has a single price. This could be a price of anything, such as a security or a commodity. This theory originated in France in the mid 1700s. This is a very important concept because it prevents the opportunity for arbitrage. Arbitrage is the act of taking advantage in a difference of prices between an identical security. For example, a person who is involved in arbitrage would purchase a security in a market in what they believe has a cheaper price and then turn around and sell it in a market that has a higher price. They would then be able to profit in the amount of the difference in price between the 2 markets.

This is all too common in our markets today, so to prevent this and make the market more efficient we must incorporate the The Law of One price. This is part of the theory of Purchase Power Parity. This theory states that the exchange rate must adjust so that the two countries have an identical price for a specific security or commodity. This will make the purchasing power identical between the two counties, and therefore eliminate the opportunity for people to participate in arbitrage. If a market can eliminate the price discrepancies then the market will ne much more efficient.

Some other factors that come into effect are the transaction and transportation costs of shipping a commodity. Tariffs also play an important role too. The opportunity for arbitrage can be affected by these kinds of issues. A perfectly efficient market will still allow a small opportunity for arbitrage, but it will be not very significant. This is still possible because of many issues that could arise. A few of these issues are local shocks, inventory fluctuations, and telegraphic and electronic transmissions. These kinds of factors stop a market from being perfectly efficient and will provide opportunities of arbitrage for those who take advantage of these conditions. The Law of One Price is a concept that is very useful and protects the consumer and society from arbitrage. It allows us to have confidence in the knowledge that we are paying the same price for the same security or commodity, despite what particular country or market that we do transactions or business.

References:

http://eh.net/encyclopedia.article/persson.LOOP

http://www.investorwords.com/2725/law_of_one_price.html

http://www.investorpedia.com/terms/l/law-of-one-price.asp