Some Meaty Evidence on the Law of One Price’ and ‘Why Prices Levels Are Lower in Poorer Countries’

VNU UNIVERSITY OF ECONOMICS AND BUSINESS Course’s name International Financial Topic 2 Present the textbook‘s case studies ‘Some Meaty Evidence on the Law of One Price’ and ‘Why Prices Levels Are Lower in Poorer Countries’ Ho Thien Anh Hoang Vu Linh Nguyen Bao Linh Vu Quoc Thinh Truong Dien Trang Vi QH 2018 E KTQT CLC 4 Lecturer Nguyen Tien Dung Date Monday, November 16th 2020 Contents 1 Remind concept of Law of one price and Price Level 2 1 1 Law of one price 2 1 2 Price Level 4 2 How is the pr.

VNU UNIVERSITY OF ECONOMICS AND BUSINESS

Course’s name: International Financial

Topic 2: Present the textbook‘s case-studies

‘Some Meaty Evidence on the Law of One Price’

and ‘Why Prices Levels Are Lower in Poorer Countries’

Ho Thien Anh Hoang Vu Linh Nguyen Bao Linh

Vu Quoc Thinh Truong Dien Trang Vi QH-2018-E KTQT CLC 4

Lecturer: Nguyen Tien Dung Date: Monday, November 16th 2020

2 How is the price of a Big Mac different among the countries and why ? 7

3 What will happen when a country applies the Law of One price and what

4 Why does a dollar when converted to the local currency at the exchange rate

5 How does the price of non-tradable goods contribute to price level differences

1 Remind concept of Law of one price and Price Level

1.1 Law of one price

The law of one price is an economic concept that under the assumption of perfect competition and if there are no transportation costs and trade barriers, the same goods must be sold for the same price in different markets

In other ways, we can understand that the law of one price takes into account a frictionless market, where there are no transaction costs, transportation costs, or legal restrictions, the currency exchange rates are the same, and that there is no price manipulation by buyers or sellers The law of one price exists because differences between asset prices in different locations would eventually be eliminated due to the arbitrage opportunity

For instance, 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 in Market A and immediately sell it for $20 in Market B, netting a profit of $10 without any true risk or shifting of the markets As securities from Market A are sold on Market B, prices on both markets should change in accordance with the changes in supply and demand, all else equal Increased demand for these securities in Market A, where it is relatively cheaper, should lead to an increase in its price there Conversely, increased supply in Market B, where the security is being sold for a profit by the arbitrageur, should lead to a decrease in its price there Over time, this would lead to a balancing of the price of the security in the two markets, returning it to the state suggested by the law of one price

According to the law of one price, if there are differences in the prices of the same goods in different markets, arbitrage will take place and eventually equalize the prices across markets The arbitrage opportunity would be achieved whereby a trader would purchase the asset in the market it is available at a lower price and then sell it in the market where it is available at a higher price Over time, market equilibrium forces would align the prices of the asset

Furthermore, the law of one price also establishes a relation between domestic and foreign prices and the exchange rates:

P = E x P*

Where:P stands for the domestic price of one particular good

P* stands for the foreign price of the same good

E stands for exchange rate The law of one price is the foundation of purchasing power parity (PPP) Purchasing power parity states that the value of two currencies is equal when a basket

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of identical goods is priced the same in both countries It ensures that buyers have the same purchasing power across global markets

In reality, purchasing power parity is difficult to achieve, due to various costs

in trading and the inability to access markets for some individuals

The formula for purchasing power parity is useful in that it can be applied to compare prices across markets that trade in different currencies As exchange rates can shift frequently, the formula can be recalculated on a regular basis to identify mispricings across various international markets

In the real world, the assumptions built into the law of one price frequently do not hold, and persistent differentials in prices for many kinds of goods and assets can

be readily observed It is called violations of the law of one price

Transportation cost is one of the parts of the differences When dealing in commodities, or any physical good, the cost to transport them must be included, resulting in different prices when commodities from two different locations are examined

Next reason is transaction costs Because transaction costs exist and can vary across different markets and geographic regions, prices for the same good can also vary between markets Where transaction costs, such as the costs to find an appropriate trading counterparty or costs to negotiate and enforce a contract, are higher, the price for a good will tend to be higher there than in other markets with lower transaction costs

Legal restrictions or legal barriers to trade, such as tariffs, capital controls, or in the case of wages, immigration restrictions, can lead to persistent price differentials rather than one price These will have a similar effect to transportation and transaction costs, and might even be thought of as a type of transaction cost

Market structure is also a reason that leads to a violation in the law of one price Because the number of buyers and sellers (and the ability of buyers and sellers

to enter the market) can vary between markets, market concentration and ability of buyers and sellers to set prices can vary as well

So, let’s connect to the differences between the price of Big Mac hamburgers at McDonalds’ restaurants all over the world in first case study It was supposed that the price of Big Macs sold in New York (US) is domestic currency, and others are foreign currencies According to the price data of hamburgers sold in different countries, we have a sales price in the US of 3.54 dollars The same hamburger, but in Norway it sells for a much higher price ($ 5.79), or as in Switzerland, the price of a Big Mac is $ 5.60, the cost of it in Denmark is $5.07, in Sweden is $4.58, and Euro areas is about

$4.38, On the other hand, there are some countries with lower selling pricesthan in the domestic market such as the price of a Big Mac in Malaysia was only $1.52, in

South Africa was around $1.66, in Russia was $1.73, Indonesia ($1.74), Thailand ($1.77), China ($ 1.83), Philippines ($ 2.07),, etc

Why is there such a large deviation in the price of hamburgers in such countries? According to the theory mentioned above and Economists survey, the main reason is due to the transport cost and government regulations There are also reasons such as product differences to suit the local market, salaries for employees, site rental costs, utilities

1.2.

Price Level

Price level is the average of current prices across the entire spectrum of goods and services produced in an economy In more general terms, price level refers to the price or cost of a good, service, or security in the economy Price levels may be expressed in small ranges, such as ticks with securities prices, or presented as a discrete value such as a dollar figure

In economics, price levels are a key indicator and are closely watched by economists They play an important role in the purchasing power of consumers as well as the sale of goods and services It also plays an important part in the supply-demand chain

When the price level is in the economy, it refers to the buying power of money

or inflation In other words, economists describe the state of the economy by looking

at how much people can buy with the same dollar of currency The most common price level index is the consumer price index (CPI)

The price level is analyzed through a basket of goods approach, in which a collection of consumer-based goods and services is examined in aggregate Changes

in the aggregate price over time push the index measuring the basket of goods higher

Weighted averages are typically used rather than geometric means Price levels provide a snapshot of prices at a given time, making it possible to review changes in the broad price level over time As prices rise (inflation) or fall (deflation), consumer demand for goods is also affected, which leads to changes in broad production measures such as gross domestic product (GDP)

In sum, price levels are one of the most watched economic indicators in the world Economists widely believe that prices should stay relatively stable year to year

so that they don't cause undue inflation If price levels rise too quickly, central banks

or governments look for ways to decrease the money supply or the aggregate demand for goods and services

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Let’s take a look at our second case study, as mentioned above, price refers to the consumer's purchasing power for a basket of goods This means that if the buyer has a high income, residents are more likely to consume one or more goods, and if the income is low, the ability to consume one or more baskets of the goods is also less

It can be explained that, for poor countries, their prices are much lower than for rich countries because of many factors For example, labor productivity in rich countries is very high, they create a lot of wealth, high-value material, and they have more assets, from which private income would increase The higher income level, the higher ability for people to consume a basket of goods This also leads to production measurements such as high GDP

2 How is the price of a Big Mac different among the countries and why ?

Transportation costs: Goods not locally will need to be imported, resulting in shipping costs Imported goods will sell at a correspondingly high level compared to goods available from the local source

When a government sales tax, such as a value added tax (VAT), is high in one country compared to another, it means that the goods will sell at a relatively higher price than in a high tax country Government intervention: Import duties raise the price of imported goods Where these are used to limit the increased supply or demand, the price of the good is also increased In countries with the same unrestricted and abundant commodity, its price will be lower

Export-restricting governments will see the price rise of troubled importing countries and fall into exporting countries as supplies increase Services are not traded

The Big Mac's price includes input costs that are not traded Therefore, these costs are not likely to be equivalent internationally These costs may include facility costs, service costs such as insurance and heating, and especially labor costs According to the PPP, in countries with relatively high non-transaction costs, goods will be relatively expensive, causing their currencies to be overestimated compared to currencies in cost countries with low non-trade service

Market competition: Goods can be priced higher in one country because the company has a competitive advantage over other sellers, because it has a monopoly or

is part of a cartel of firms price manipulation

A company's desired brand can allow it to sell at a premium Conversely, it can take years to offer at low prices to establish the brand and add a premium, especially if there are cultural or political barriers to overcome Inflationary

The rate of the price of the goods (or the cart) is changing in countries, the inflation rate can indicate the value of the currencies of those countries.This relative

PP will overcome the demand for the goods is the same for the absolute PPP test discussed above

3 What will happen when a country applies the Law of One price and what policy makers should do?

Mcdonald used to remarkably succeed in Iceland, even the Prime Ministry bought the Big Mac However, Mcdonald was forced to leave Iceland’s market One

of the reasons for this failure is the change in the exchange market causing the rise in exporting’s cost

In the term of 2006, Iceland had a dollar BigMac price of 7.44$ and a whopping 131 percent currency overvaluation on the Big Mac scale Unlike the other country, Iceland had to import the ingredients for Big Mac, therefore the price of an Iceland’s BigMac depends on the exchange rate of Dollar and Króna and a burger was considered as an imported good

When Iceland was stuck in an economic crisis, Iceland's currency depreciated from 68 Krona per Dollar to around 120 per dollar As a result, the cost for the BigMac’s ingredients rose and the price of a BigMac rose as well Although Iceland McDonald increased the price to keep their profit, they still suffered from incredible loss Because when the domestic currency depreciates, the price of imported goods become more expensive, and people tend to change to use the domestic goods

Jon Gardar Ogmundsson, a key figure in the McDonald's scene in Iceland at the time, said: “That makes no sense One kilo of onions is imported from Germany and costs the equivalent of a bottle of premium whiskey.” Finally, the franchise owners closed all three restaurants and the McDonald withdrew from Iceland’s market

The transportation costs cause a considerable price divergence between Big Mac in the US and Iceland The price of a burger was formed based on the PPP, which means the same good must be sold for the same price in the different markets However, the trade barriers and transportation cost cause the PPP and Law of One price to become irrelevant In Iceland, for example, the transportation cost of ingredients was added to the price of a burger Unfortunately, Iceland's currency depreciated due to the crisis and the cost rose more and more

The case study of Law of one price concluded that the PPP exchange rate equates to some international prices of goods & services, and we might not expect the PPP not to hold in the long period It can be explained by the following reasons:

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- The PPP condition assumes that there are no transaction costs In the presence of transaction costs, PPP will not hold exactly Instead the transaction cost will create a band within which the deviation from PPP, that is real exchange rates, can fluctuate without setting into motion international arbitrage of commodities This is because, in the presence of transaction costs, arbitrage activity will not take place for those goods for which profits from arbitrage is lower than the transaction cost

- The PPP condition assumes that all goods are traded internationally But we know that many are not traded internationally For instance, medical services, housing, etc are not traded internationally As the prices of non traded goods change, the price indices change as well But the exchange rates may not vary, since changing prices of nontraded goods would not give rise to international trade flows as a result, exchange rates will not change as we expect under PPP

- Richer countries have higher price levels than poor countries Rich cities or states

in the U.S have higher price levels than poor cities-states in the U.S The reason is that the price of nontraded goods is higher in wealthy nations For instance, medical examination is higher in the U.S than in Turkey

- Since the price of nontraded goods enter into the price indices and hence into the real exchange rate-deviation from PPP- this means that the deviation from PPP may not be constant at all

- The two main determinants of the relative price of non traded goods are income and technology 5

high relative price of nontraded goods

goods (mainly for manufactured goods) than it has for nontraded goods Improvements in technology means high factor productivity and attractive returns to labor and technology in the traded goods sector As resources move into that sector, the relative supply of nontraded goods declines This also contributes to high relative prices of nontraded goods

o So countries that experience rapid technological improvements and rising incomes should also experience a real appreciation of their currency over time

In conclusion, the PPP exchange rate should not be held in the long run due to the changing exchange rate market may cause some damage for the firms, as well as