The law of one price is an economic law stated as: "In an efficient market all identical goods must have a single price."
The intuition for this law is that all sellers will flock to the highest prevailing price, and all buyers to the lowest current market price. In an efficient market the converge on one price is instant.
An example: Financial markets
Commodities can be traded on financial exchanges , where there will be a single offer price , and bid price . Although there is a small spread between these two values the law of one price applies, because no-one will sell the commodity at a different price than the market maker; a higher price would have no takers, and a lower price would be charity.
For the same reason, a stock market obeys the law of one price.
In the derivatives market the law applies to financial instruments which appear different, but which resolve to the same set of cash flows. InvestorWords states this, as:
"a security must have a single price, no matter how that security is created. For example, if an option can be created using two different sets of underlying securities, then the total price for each would be the same or else an arbitrage opportunity would exist."
Where the law does not apply
- The Balassa-Samuelson effect gives examples of markets between which the law of one price does not apply.
- The law does not apply intertemporally, so prices for the same item can be different at different times in one market. The application of the law to financial markets in the example above is obscured by the fact that the market maker's prices are continually moving in liquid markets. However, at the moment each trade is executed, the law is in force (it would normally be against exchange rules to break it).
