Law of one price & market integration

1. Law of one price & market integration

2. Spatial market equilibrium • We saw last lecture that • Price differentials may induce arbitragers to move product from low to high price markets …if it is profitable! • Physical balance must be maintained • Arbitrage drives prices toward convergence • Physical balance means excess demand is met by excess supply

3. Implications of spatial arbitrage …..if there is competition! (three new concepts) • Law of one price (sort of…) • Market integration (why?) • Price transmission • Trade distortion

4. Law of one price If two spatially separated markets are prevented from trading with each other, we say these markets are “autarkies”. Consider Kansas and Missouri, suppose Kansas prohibited sale of beer….. Pj > Pi + AC(Yij ) If spatial arbitrage is allowed, and is competitive, then Pj= Pi + AC(Yij )

5. Trade distortion • Autarky is an extreme case • Trade can also be “distorted” by nonmarket forces or factors that affect the cost or profitability of spatial arbitrage. • Examples we will see soon: taxes, subsidies, etc.

6. Law of one price If we there were no barriers to trade between two economies at different spatial locations, Then, we could say that spatial arbitrage results in “sort of” only one price in the two markets…… Pj = Pi + AC(Yij )

7. Implication of spatial arbitrage • Arbitrage drives prices toward equality in source and destination locations (Law of one price) • Arbitrage moves excess supply in the low price location to satisfy excess demand in the higher priced location. This movement of physical product “integrates” the two locations into a “virtual” location.  Spatial arbitrage leads to “market integration”

8. Price transmission Arbitrage links prices  the drivers of price in source location affect the price in the destination location (and vice versa!) chg Drivers(i) chg P(i)  adjustment of arbitrage (i,j)  chg P(j) So we say arbitrage leads to “price transmission”

9. Why price transmission ? Recall D is demographics Physical balance is established Excess demand = Excess supply 1) Ydti (Pit ,Ijt ,Djt ) – Ysti (Pit ,Rjt ,Kjt) = Ystj (Pjt ,Rjt ,Kjt) - Ydtj (Pjt ,Ijt , Djt ) Arbitrage equilibrium in price is established • Pit = Pjt + ACij(Aijt)  (Iit ,Dit , Rit ,Kit , Ijt , Djt Rjt ,Kjt , Aijt)  ( Pit Pjt )

10. Why price transmission ? Drivers in i and j  prices (Ijt ,Djt , Rjt ,Kjt , Ijt , Djt Rjt ,Kjt , Aijt)  ( Pit Pjt ) So, it you want to predict and analyze prices just collect data for the drivers as a start! If a driver changes, both prices will change! (Ijt +Δ Ijjt, Djt , Rjt ,Kjt , Ijt , Djt Rjt ,Kjt , Aijt)  ( P+it P+jt )

11. How does price transmission happen? Sometimes instanteous…..but Chg in driver  chg in price  new opps for arbitrage  chg in arbitrage • New prices • New quantity flows

12. Bottomline • Law of one price (LOP) is not a reality ………but sometimes close…. • Price changes are transmitted through arbitrage ………..sometimes imperfectly • Arbitrage “integrates” markets….. “somewhat”

13. Gasoline prices Nominal premium gasoline prices, taxes included, and converted to US$ per litre. The spot price is the Rotterdam price of premium gasoline (usually given in US$/bl.) Source: The World Energy Database, ENERDATA s.a. (France).

14. Slaughtered beef flows

15. Do egg prices reflect LOP? Why not?

16. Market Integration Test for Pacific Egg MarketsQinghua LiuH. Holly Wang • Evidence is found that there are physical flows among the six Pacific states, makes market integration possible. • Results indicate they follow one common stochastic trend in the six-market price series. • LOP is rejected. • Transportation and other transaction costs may prevent the markets in the six states from being perfectly integrated in the short-run. • Arizona, California, and Washington play dominant roles in price formation on the Pacific egg market,

17. Examples • What is the G-7? G-20? • Why were these orgs formed?

18. Why NAFTA? Why WTO? • By taking out distortions to trade flows, excess supply regions can ship to excess demand regions • Product prices are reduced in importing regions • Product prices are increased in exporting regions How much would the shirt you are wearing cost if it were not produced in Malaysia?

19. Spatial market integration Let’s ignore the distortions for a minute…..

20. Market integration by spatial arbitrage Excess Supply Region P1 =AC(Y1) Excess Demand Region P2 =AC(Y2) Initially, with autarky, P1 < P2 If product arbitrage is feasible, competition will establish Spatial arbitrage equilibrium condition P2 = P1 + AC(Y12 ) so prices will be linked to approx LOOP Physical balance will imply excess supply in region 1 = excess demand in region 2 For all practical purposes, the two regions are one! “integrated”

21. Market integration • We define two markets that are spatially separated as integrated, if 1) the price difference between the two markets is consistent with zero profits from any further spatial arbitrage, 2) physical balance exists across the two markets, i.e. total demand in two mkts = total supply in two mkts

22. Market integration by spatial arbitrage Excess Supply Region Excess Demand Region P2 = P1 + AC(Y12 ) Region 1’s Current Supply – Region 1’sCurrent Demand = Region 2’s Current Demand – Region 2’sCurrent Supply