TESTING INTERNATIONAL PRICE TRANSMISSION UNDER ...

Price Transmission and the Law of One Price
The fundamental definitions are given (paragraph 2.2), underlying the relations
existing between them, and the appropriateness of their use in the analysis. In
paragraph 2.3, some major problems due to the reliability of the hypothesis at the
basis of the LOP to hold in practice are described, which is strongly interlinked
with a first assessment of the problems inherent to empirical models relying only
on price data (which will be extensively dealt with in chapter 3). Paragraph 2.4
concludes.
2.2 Some basic concepts
The study of price transmission mechanisms implies referring to a number of
economic concepts for which, unfortunately, no common definitions exist in
literature (Fackler and Goodwin 2001, p.976). The most important ones will here
be briefly revised.
The basic notion is the spatial arbitrage condition, which can be formalized as
in equation (2.1),
14
Pj - Pi ≤ Rij
(2.1)
where P indicates the prices in the two spatially separated locations i and j, and Rij
is the cost of moving the good considered from i to j. The spatial arbitrage
condition implies that the difference between prices in different locations will
never exceed transport costs 3 , or otherwise the profiting opportunities would be
immediately exploited by arbitrageurs: they would buy the goods in the market in
which the price is lower, and sell them in the one where it is higher. Other things
equal, the price would then go up in the first market due to the increased demand,
and go down in the second one because of the increase of supply, towards
equilibrium. In the short run, actual prices may diverge from the spatial arbitrage
condition, but the actions of the arbitrageurs are expected to make it valid in the
long run, moving the price spread toward the transport cost 4 . More realistically,
explicit arbitrage for nowadays markets is the outcome of the actions of a number
of dispersed producers who evaluate the market conditions existing in several
terminal markets and sell in the market with the highest price. Net returns and
prices are equalized across markets; prices are expected to differ by no more than
the difference in the costs of selling in one market versus another (Goodwin and
Piggott 2001, p.302).
3 In this paragraph, for the sake of simplicity, the term transport cost is meant to include all costs of arranging
transactions between spatially different locations. See paragraph 2.3 for a more detailed explanation.
4 In this respect, Stigler defines the market as the spatial area “within which the price of a good tends toward
uniformity, allowance being made for transportation costs” (1966 cited Fackler and Goodwin 2001, p.974).