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Chapter 16: Problem 1

What is the law of one price? What is arbitrage?

Short Answer

Expert verified
The Law of One Price is an economic theory that states an identical good should cost the same across all markets when prices are expressed in a common currency, assuming no trade restrictions or transaction costs. Arbitrage is the practice of profiting from price differences of an identical good in different markets. The Law of One Price holds true in an absence of arbitrage opportunities.

Step by step solution

01

Defining the Law of One Price

The law of one price refers to the economic theory that states the price of an identical good or asset must have the same price globally regardless of the country, when prices are expressed in a common currency. This is under the assumption that there are no trade restrictions or transaction costs.
02

Defining Arbitrage

Arbitrage, in the context of economics and finance, is the practice of capitalizing on the price differences of an identical good or asset across different markets. Traders who practice arbitrage look to purchase a good or asset at a lower price in one market and then sell it at a higher price in another thereby making a profit without any risk or net cash investment.
03

Explaining the Relation between the Law of One Price and Arbitrage

These two concepts are related because the existence of arbitrage opportunities violates the law of one price. In other words, if the law of one price holds true, then there should be no arbitrage opportunities. When such opportunities arise, traders take advantage of the price differences affecting the demand and supply, which eventually leads to price equality or the law of one price.

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Most popular questions from this chapter

While in Shanghai, China, to teach an MBA course, Craig Richardson, an economics professor from WinstonSalem State University, asked his American students to haggle with sellers in a market where prices for the same items can vary widely. Professor Richardson explained that the same item with the same sticker price at different market stalls can have a final price that varies "by \(1,500 \%\) or more, depending on the negotiating skills of the buyer." a. Do Shanghai merchants practice price discrimination? Briefly explain. b. Which consumers are likely to pay the highest prices for similar items in the Shanghai market?

Give an example of a firm using a two-part tariff as part of its pricing strategy.

In early \(2017,\) a headline in the Wall Street Journal read: "Pricey Virtual- Reality Headsets Slow to Catch On." Is it possible that Sony, Facebook, and the other firms producing virtual-reality headsets were better off keeping prices high when initially offering them for sale, even if the result was a smaller quantity sold? Briefly explain.

In 2017 Disney offered a complex variety of ticket options for admission to Walt Disney World. a. Disney charged different prices for one-day tickets to its Disney World parks, depending on the time of the year. Summer and the winter holiday season had the highest ticket prices, while most weeks in the winter and spring had the lowest. But people buying tickets that could be used for more than one day paid the same price whatever time of the year they attended. Briefly explain what assumptions Disney must be making for this pricing strategy to increase its profit. b. A Disney World guide book notes that families have many different ticket options to choose from and that, "adding to the complexity, Disney's reservation agents are trained to avoid answering \(\ldots\) which ticket option is best.' Many families, we suspect, become overwhelmed \(\ldots\) and simply purchase a more expensive ticket with more features than they'll use." Can the complexity of Disney's ticket options be a form of price discrimination? If so, which people are likely to pay the higher ticket prices and which people the lower ticket prices?

During the nineteenth century, the U.S. Congress encouraged railroad companies to build transcontinental railways across the Great Plains by giving them land grants. At that time, the federal government owned most of the land on the Great Plains. The land grants consisted of the land on which the railway was built and alternating sections of 1 square mile each on either side of the railway to a distance of 6 to 40 miles, depending on the location. The railroad companies were free to sell this land to farmers or anyone else who wanted to buy it. The process of selling the land took decades. Some economic historians have argued that the railroad companies charged lower prices to ship freight because they owned so much land along the tracks. Briefly explain the reasoning of these economic historians.
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