The law of price is the economic theory that states the price of an identical security, commodity or asset traded anywhere should have the same price regardless of location when currency exchange rates are taken into consideration, if it is traded in a free market with no trade restrictions. The law of price exists because differences between asset prices in different locations should eventually be eliminated due to the arbitrage opportunity.
The law of price theory is the underpinning of the concept of purchasing power parity. Purchasing power parity states that the value of two currencies is equal when a basket of identical goods is priced the same in both countries. 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 can be recalculated on a regular basis to identify mispricing’s across various international markets.
Theory of Price
The theory of price is an economic theory whereby the price for any specific good or service is based on the relationship between supply and demand. The theory of price posits that the point at which the benefit gained from those who demand the entity meets the seller’s marginal costs is the most optimal market price for the good or service.
Supply and Demand and Their Relation to Price Theory
Supply denotes the number of products or services the market can provide including tangible goods such as automobiles, or intangible goods, such as the ability to make an appointment with a skilled service provider. In each instance, the available supply is finite in nature. There are only a certain number of automobiles available and only a certain number of appointments available at any given time.
Demand applies to the market’s desire for the item, be it tangible or intangible. At any time, there is also only a finite number of potential consumers available. Demand may fluctuate depending on a variety of factors such as whether an improved version of a product is available or if a service is no longer needed. Demand can also be impacted by an item’s perceived value, or affordability, by the consumer market.
Equilibrium occurs when the price points are such that the number of items available, the supply, is consumed by potential customers. If the price is too high, customers may avoid the good or service, resulting in excess supply. In contrast, if a price is too low, demand may significantly outweigh the available supply. Economists use price theory to find the selling price that brings supply and demand as close to the equilibrium as possible.
Real World Example
Firms often differentiate their product lines vertically versus horizontally considering consumers’ differential willingness to pay for quality. According to an article published in Marketing Science research by Michaela Draganska of Drexel University and Dipak C. Jain of INSEAD, many firms offer products that do not vary in quality but with characteristics such as color or flavor. Apple, for example, offers different iPhone models with varying prices and capabilities but each model comes in a variety of colors that are the same price. The study found that using uniform prices for all products in a product line is the best pricing policy. If Apple, for example, charged a higher price for a silver iPhone X versus a space gray iPhone X, demand for the silver model might fall, the supply of the silver model would increase, and Apple might be forced to reduce the price of that model.