Purchasing power parity and the law of one price are two rel

Purchasing power parity and the law of one price are two related concepts.

A. Explain what is meant by the law of one price. Also explain why a person or nation could profit if this law does not hold. (3 points)

B. Offer three reasons why the law of one price might not hold for some goods. (3 points)

C. Explain what is meant by purchasing power parity. Also explain how purchasing power parity relates to the law of one price. (3 points)

Solution

Part A.) The law of one price says that prices of similar goods should be same in two different markets when there are no transportation costs and no taxes in two markets.If prices are not identical, then person or nation can buy good in low price market and sell it in high price market to make profit.

Part B) Reasons for violation of law of one price could be transportation costs between different locations,taxes in different nations,input prices can also vary in different states.

Part C) Purchasing power parity states that exchange rates between currencies are in equilibrium when their purchasing power is same in both countries.Exchange rate between two countries is equal to ratio of two nation\'s price level of fixed basket of goods.

The law of one price is another way of stating PPP. But law of one price hold for individual goods but PPP applies to general price level.If law of one price holds for all goods, then PPP is also true.