Why the Law of One Price Is Not Always Valid

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There are several reasons for the PPP theory to not hold or why the law of one price is not always valid. The main reasons are: Restrictions on international trade: Trade barriers such as import and export tariffs, duties etc. can erode much of the difference in price which may exist between two countries. For example if there is a 100% tariff on import of steel into India, the domestic prices of steel(which is a tradable good) in India will continue to be higher than the country of comparison, and any arbitrage is impractical. Transportation and logistics costs: If it is very expensive to transport goods from one market to another, we would expect to see a difference in prices in the two markets. This even happens in places that use the same currency; for instance the price of certain commodities (e.g., corn) is cheaper in cities such as Chicago when compared to Alaska.

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This effect maybe more pronounced when there are huge economies of scale in production and there tend to be few centers of production. Shelf life: It may be physically impossible to transfer goods from one market to another. The lettuce which is used in the Big Mac may be cheaper in the United States but it does not help in reducing the price of Lettuce in Dubai, because by the time the American lettuce reaches Dubai, it may have turned brown. Location: The monthly rent to lease a location for McDonalds may be cheaper in Bangalore, India when compared with certain cities in United States, but one cannot buy a piece of land in India and move it to the United States. Wage rates: Labor costs in India or Mexico (which is much closer to the Unites States) are much lower than the labor costs in the Unites States, but one cannot bring Mexican or Indian employees in the United States and pay them lower than market wages. Skills gap and transferability: Some country may have abundant highly skilled people engaged in a certain task which may reduce the price of the goods they produce in their home country due to their lower wage rates. However it may not be possible for another country to develop a pool of individuals skilled in those tasks in a short period of time. So while purchasing power parity theory helps us understand exchange rate differentials, exchange rates do not always converge in the short term. It is empirically known that PPP does not hold (actual and PPP rates are different) within a day, a week, a month, a year, and even within a few years. But it is often observed that PPP is more firmly established as a long-term tendency. W...

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