One Price Theory- Purchasing Power Parity Theory

The law of one price is the economic theory that the price of a given security, commodity or
asset has the same price when exchange rates are taken into consideration. The law of one price
is another way of stating the concept of purchasing power parity. The law of one price exists due
to arbitrage opportunities.

One Price Theory:

The law of one price is the economic theory that the price of a given security, commodity or
asset has the same price when exchange rates are taken into consideration. The law of one price
is another way of stating the concept of purchasing power parity. The law of one price exists due
to arbitrage opportunities.

The theory first circulated in the 17th century, but the economist most credited with the growth
of purchasing power parity is Karl Gustav Cassel (1921). His work then on exchanges rates after
the collapse of the gold standard shaped the central idea behind the theory of today. The theory
of the law of one price (LOP) forms the foundation of the purchasing power parity hypothesis,
and states that identical goods in different countries should trade at the same price once
converted to a common currency:

P n  EP *n

Where P n is the domestic currency price of a good, E (actual nominal exchange rate) is the
domestic currency price of foreign currency and P*n is the foreign currency price of a good.

The key process that is responsible for the convergence of prices is arbitrage. Arbitrage is the
process of buying or selling a good in order to exploit a price differential so as to make a risk-
less profit. Once the process starts, it continues until prices have converged to the extent that no
more profit can be made.

The law of one price theory can applied to both an intra-country and an international setting; all
that is required is conversion to a common currency. The theory does somewhat abstract from
reality, since in practice crossing a border does affect pricing. Currently, there are still numerous
aspects of international trade that have an impact on country specific prices. Transport costs,
tariffs and other non-tariff barriers influence prices and last two distort the prices that are be paid
for goods. We need to account for these distortions when working with international prices. The
main principle however does not change and price equalization should occur through arbitrage
and a greater degree of free trade.

Law of One Price:

If the price of a security, commodity or asset is different in two different markets, then an
arbitrageur purchases the asset in the cheaper market and sells it where prices are higher. When
the purchasing power parity doesn't hold, arbitrage profits will persist until the price converges
across markets.

The law of one price is in place to prevent investors from taking advantage of a price disparity
between markets in a situation known as arbitrage. If a particular security is available for $10 in
Market A but is selling for the equivalent of $20 in Market B, investors could purchase the
security on Market A and immediately sell it for $20 on Market B, netting a profit without any
true risk or shifting of the markets.

As securities from Market A are sold on Market B, prices on both markets shift in accordance
with the changes in supply and demand. Over time, this would lead to a balancing of the two
markets, returning the security to the state held by the law of one price.

In efficient markets, the occurrences of arbitrage opportunities are low, most often caused by an
event causing a sudden shift occurring in one market before the other markets are effected.

Law of One Price and Commodities:

When dealing in commodities, the cost to transport the goods must be included, resulting in
different prices when commodities from two different locations are examined. If the difference is
goes beyond the transportation costs, this can be a sign of a shortage or excess within a particular
region.

Purchasing Power Parity:

Purchasing power parity describes the effects controlled by the theory of the law of one price. It relates to
a formula that can be applied to compare securities across markets that trade in different currencies. As
exchange rates can shift frequently, the formula must be recalculated on a regular basis to ensure equality
across the different international markets.

In practice we are more interested in aggregate levels of prices or a collection of goods. It

provides more information on the economic state of national affairs and provides a base for
international comparison, which is becoming ever more important. The step from LOP to PPP
requires an aggregation of LOP and argues that national price levels should be equal once
conversion to a common currency is made
 P  EP 
with P being the domestic price index, E (actual nominal exchange rate) domestic currency price of
foreign currency and P  the foreign price index.

Macroeconomic analysis relies on several different metrics to compare economic productivity

and standards of living between countries and across time. One popular metric is purchasing
power parity (PPP).

Purchasing Power Parity (PPP) is an economic theory that compares different countries'
currencies through a market "basket of goods" approach. According to this concept, two
currencies are in equilibrium or at par when a market basket of goods (taking into account the
exchange rate) is priced the same in both countries.

This is how the relative version of PPP is calculated:

Where:

"S" represents exchange rate of currency 1 to currency 2

"P1" represents the cost of good "x" in currency 1

"P2" represents the cost of good "x" in currency 2

To make a comparison of prices across countries that holds any type of meaning, a wide range of
goods and services must be considered. The amount of data that must be collected, and the
complexity of drawing comparisons makes this process difficult. To facilitate this, the
International Comparisons Program (ICP) was established in 1968 by the University of
Pennsylvania and the United Nations. Purchasing power parities generated by the ICP are based
on a worldwide price survey that compares the prices of hundreds of various goods. This data, in
turn, helps international macroeconomists come up with estimates of global productivity and
growth.

Every three years, the World Bank constructs and releases a report that compares various
countries in terms of PPP and U.S. dollars.

Both the International Monetary Fund (IMF) and the Organization for Economic Cooperation
and Development (OECD) use weights based on PPP metrics to make predictions and
recommend economic policy.

These actions often impact financial markets in the short run.

Some forex traders also use PPP to find potentially overvalued or undervalued currencies.
Investors who hold stock or bonds of foreign companies may survey PPP figures to predict the
impact of exchange-rate fluctuations on a country's economy.

PPP: The Alternative to Market Exchange Rates

Using PPPs is the alternative to using market exchange rates. The actual purchasing power of
any currency is the quantity of that currency needed to buy a specified unit of a good or
a basket of common goods and services. PPP is determined in each country based on its
relative cost of living and inflation rates. Purchasing power plus parity ultimately means
equalizing the purchasing power of two differing currencies by accounting for differences in
inflation rates and cost of living

The Big Mac Index: An Example of PPP

As a light-hearted annual test of PPP, The Economist has tracked the price of McDonald's
Corp.’s (MCD) Big Mac burger in many countries since 1986.The highly publicized Big Mac
Index is used to measure the purchasing power parity (PPP) between nations, using the price of a
Big Mac as the benchmark. The Big Mac index suggests that, in theory, changes in exchange
rates between currencies should affect the price that consumers pay for a Big Mac in a particular
nation, replacing the "basket" with the famous hamburger.

For example, if the price of a Big Mac is $4.00 in the U.S. as compared to 2.5 pounds sterling in
Britain, we would expect that the exchange rate would be 1.60 (4/2.5 = 1.60). If the exchange
rate of dollars to pounds is any greater, the Big Mac Index would state that the pound was
overvalued, any lower and it would be under-valued.

That said, the index has its flaws. First, the Big Mac's price is decided by McDonald's Corp. and
can significantly affect the Big Mac index. Also, the Big Mac differs across the world in size,
ingredients, and availability. That being said, the index is meant to be light-hearted and is a great
example of PPP that is used by many schools and universities to teach students about PPP.

GDP with PPP

One way to think of what GDP with PPP represents is to imagine the total collective purchasing power of
Japan if it were used to make the same purchases in U.S. markets. This only works after all yen are
exchanged for dollars, otherwise, the comparison does not make sense. The net effect is to describe
how many dollars it takes to buy $1 worth of goods in Japan as opposed to in the U.S.
Obstacles to Purchasing Power Parity:

Through the years much study has been undertaken to find empirical evidence in support of the
purchasing power parity hypothesis. Absolute PPP has almost no empirical foothold and research
has tended to focus on relative PPP. Findings have shown that deviations from PPP are
extremely volatile and large in the short run, and until recently no conclusive evidence has been
found of long-run convergence. Most findings point in the direction of Rogoff’s (1996) findings.
He finds that deviations from PPP seem to die out at a slow rate of 15 percent per annum. This
implies that half-life deviations from PPP die out at a rate of 3-5 years, and this is to slow even
when accounting for nominal rigidities. It is also surprising because most economists believe that
PPP should play an anchor role in determining the value of real exchange rates.

So why does PPP fail? Basic reasons for failure are the existence of transport costs, tariffs, non-
tariff barriers and information costs. Crossing borders and getting goods to consumers still has a
substantial effect on prices. Rogers and Jenkins (1995) illustrate the effect of borders by
revealing that crossing borders does significantly influence relative price differentials, and that
these differentials tend to be persistent.

References:

Balassa, B. (1964), “The purchasing power parity doctrine: A reappraisal,” Journal of Political
Economics, pp. 584-96

Bergsten, F. (1997), “The Dollar and the Euro,” The Council on Foreign Affaires

Cassel, G. (1921), “The world’s money problems,” E.P Duton and Co.

Cumby, R.E. (1997), “Forecasting exchange rates and relative prices with the hamburger
standard: Is what you want what you get with McParity?” National Bureau for Economic
Research, Working Paper Nr. 5675, pp. 9-10

Heston, A. Summers, R. and Aten, B. (2002), Penn World Table Version 6.1, Center for
International Comparisons of Production, Income and Prices, University of Pennsylvania

Krugman, P.R. (1997), “Purchasing power parity and exchange rates: Another look at the
evidence,” Journal of International Economics 8(3), pp. 397-407

Lutz, M. (2001), “Beyond burgernomics and MacParity: forecasting exchange rates with micro-
level price data,” Institute of Economics, University of St. Gallen, Switzerland, pp. 8-9