TESTING INTERNATIONAL PRICE TRANSMISSION UNDER ...

Price Transmission and the Law of One Price
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i.e., the LOP.
The LOP is at the basis of the Purchasing Power Parity (PPP), which can be
considered as its aggregate version stated in terms of price indices, and whose
assumptions are thus far more restrictive.
The LOP, whose the very “law” designation reflects the faith placed in its
adherence (Fackler and Goodwin 2001, p.977) has a very long tradition in
economics which dates back to Marshall (1890 cited Fackler and Goodwin 2001,
p.977) but, nevertheless, most of the empirical tests are against it. Miljkovic
(1999, p.126), asserts that “although called a law, it has probably been violated
probably more than any other economic laws (on the basis of the results of
numerous empirical studies)”. A detailed description of why this might be the
case will be given in paragraphs 2.3 and 3.4, as it might depend both on the strong
assumptions underpinning it and on the inherent features of the empirical models
used.
Another basic concepts is the one of competitive market equilibrium, that is a
condition in which extraordinary profits are exhausted by competitive pressures,
regardless of whether this results in physical trade flows between markets (Barrett
and Li 2002, p.394) 9 . Analogously, the spatial market efficiency can be taken as a
synonymous of the spatial arbitrage condition. Regional or interregional markets
characterised by arbitrage opportunities can be considered as inefficient, since
markets should produce prices that accurately reflect all available information
about demand and supply conditions as well as transaction costs. Market
efficiency implies that, in a competitive market with perfect information, arbitrage
will ensure that price differentials in related spatial and temporal markets will
reflect all marketing costs. In spatially related markets, price differentials will
reflect transportation costs; in temporally related markets, the cost of storage
(Hui-Shung and Griffith 1998, p.369). However, in developing countries, the
concept of spatial market efficiency may also encompass an assessment of the size
of the transaction costs (Fackler and Goodwin 2001, p. 980).
For the concept of spatial market integration, instead, Barrett and Li (2002,
p.292) explicitly make clear that it just reflects the tradability of products between
spatially distinct markets, irrespective of the presence or absence of spatial market
equilibrium and efficiency. In other words, market integration is a quantity based
indicator of tradability, while, as explained, efficiency is a price-based indicator,
7 If transaction costs are a constant proportion of prices (τ1t = λ 1tP 1t), then the first order conditions imply P 1t
=(1- λ 2 )/(1-λ 1 ) P 2t = β 0P 2t, which, as explained in the following paragraph, is a multiplicative version of the
LOP which can be put in a linear form by taking the logarithms of the prices.
8 If delivery lags are different, for example k = 0 and j > 0, it becomes P1t = β 0E t{P 2t+j}; see paragraph 3.2.4.
9 Markets may maintain spatial linkages even when direct trade doesn’t occur between them. This happens if
selling agents from both markets compete in a third one and perfect competition holds in all three markets.
Even in the absence of trade, spatial market linkages might be disciplined under the threat of competition;
prices differences are kept between the cost band (Goodwin et al. 1999, p.160).
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