TESTING INTERNATIONAL PRICE TRANSMISSION UNDER ...

Price Transmission and the Law of One Price
2.3 A theoretical problem: why should the LOP hold?
The previous paragraph provides a general outline of the fundamental
theoretical concepts relative to price transmission analysis. As it will be clearer in
chapter 3, where the empirical models which have been used for the study of price
transmission are presented, what emerges is a controversial picture. Indeed, not
only are even the basic definitions not fully agreed upon researchers, but
empirical analysis has brought a very mixed evidence (see annex A for a review).
In this paragraph, some concluding remarks concerning the reliability of the
LOP hypothesis to hold in practice will be given, which might be the cause of the
absence of empirical evidence supporting it. This issue is nonetheless strictly
entangled, as we will see in chapter 3, to the underlying hypothesis and properties
of the models used, and this is particularly true if they rely only on price data
(paragraph 3.4).
It is well recognized that, though denoting this concept a “law” reflects the
considerable faith in its adherence (Fackler and Goodwin 2001, p.977), the
simplicity of the LOP can be easily questioned, as its assumptions prove to be
quite restrictive and unlikely to hold in practice. Williamson (1986 cited Fackler
and Goodwin 2001, p.975) and Miljkovic (1999, p.126) note that the LOP has
been violated by empirical tests probably more than any other economic laws.
The LOP is expected to regulate spatial price relations in a frictionless
undistorted world; the premises of full price transmission and market integration
correspond to those of the standard competition model (Conforti 2004, p.1).
Following Miljkovic (1999) and Conforti (2004), some major groups of factors
that prevent prices from convergence can be identified 12 .
Transaction costs play a crucial role while investigating market efficiency, and
this is particularly important in agriculture, since they are relevant if compared to
the value of the commodities considered (Fackler and Goodwin 2001, p.973;
Barrett 2001, p.27). Unless certain assumptions are made, their treatment is not
easy; and, even if the LOP is satisfied, if transaction costs are large and volatile,
prices don’t move together. Transaction costs have many components. In addition
to the very transport costs (normally, freight rates, i.e. per unit transportation
costs), we also have variable transport costs (insurance, financing, hedging,
contracting, technical barriers to trade), exogenous costs components
(underwriting fees, testing charges), unit average duties, and other immeasurable
transaction costs (such as search costs and exchange rate variability; Barrett 2001,
p.23); in other words, all other information, negotiation, monitoring and
enforcement costs (Williamson cited Conforti 2004, p.2). Linnemann (1996 cited
12 In general, the conditions necessary for adherence to factor price equalization are even stronger than those
required for output markets; evidence supporting factor market integration is weak (Fackler and Goodwin
2001, p. 976).
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