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The Law of One Price in International Trade: A Critical Review

Article  in  Applied Economic Perspectives and Policy · April 1999

DOI: 10.2307/1349976

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 Review of Agricultural Economics-- Volume 21, Number 1 --Pages 126-139

T h e L a w of O n e P r i c e in I n t e r n a t i o n a l
Trade: A C r i t i c a l R e v i e w

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Dragan Miljkovic

The law of one price (LOP)is one of the most frequently tested economic laws. Although called
a law, it has probably been violated more than any other economic law (on the basis of the
results of numerous ernpirical studies). Furthermore, the LOP is often utilized as the building
block in intemational agricultural trade models without previously checking the validity of
that assumption for that particular commodity. This can sometimes lead to erroneous conclu-
sions that can have serious consequences on policy-rnakingdecisions. This article represents a
critical review of recent works that discuss how some factors, such as transportation (trans-
action) costs, tariffs, nonta¡ barriers, pricing to market, exchange rate risk, and trade region-
alization, can prevent market arbitrage to force closer convergence of intemational prices. The
validity of some methods often used for testing the LOP, such as cointegration analysis, is
critically reviewed as well.

he law of one price (LOP) states that once prices are converted to a common
T currency, the same good should sell for the same price in different countries.
In other words, for any good i, P; = E ~ , where Pi is the domestic-currency price
of good i, ~ is the foreign currency price, and E is the exchange rate, defined as
the home-currency price of foreign currency. Some economists recognized that the
LOP is violated frequently (e.g., Giovannini; Isard; Knetter 1989, 1993, 1994; Rich-
ardson). However, those who are not familiar with recent literature in that area
might be surprised by the pervasiveness of the disparities. Not to be rnistaken, the
LOP holds very well for some highly traded commodities, for example, gold (Ro-
goff). However, the empirical evidence in most cases does not support the hypoth-
esis that the deviations from the LOP dampen quickly. Such instances are rather
the exception than the rule. Thus, it is legitimate to ask the following question for
traded goods: How is it possible that market arbitrage does not force closer con-
vergence of intemational prices?

9 Dragan Miljkovic is a postdoctoral fellow, Trade Research Center, Montana State

Univr and adjunct assistant professor, Department of Agriculturat Economics and
Economics, Montana State Uni~r
 The Law of One Price in International Trade 127

Table 1. Relative prices of Big Macs in s e l e c t e d c o u n t r i e s

Country Price of Big Mac (in U S. dollars)

Switzerland 5.20
Denmark 4.92
Japan 4.65
Belgium 3.84
Germany 3.48

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Spain 2.86
Italy 2.64
United States 2.32
Canada 1.99
Russia 1.62
Hong Kong 1.23
China 1.05

Source: The EconomisL 1995.

An example of how prices of a same or very similar good differ across different
countries would be the infamous Big Mac example (The Economist). Big Mac prices
differ widely across countries (table 1). Big Macis not well transportable in its final
form, but major components, such as the frozen beef patty and sauce ingredients,
are highly traded. On the other hand, restaurant space and local labor inputs need-
ed to cook and serve the hamburgers are basically nontraded. Other reasons for
Big Mac price differentials are the inclusion of value-added taxes in some countries
or the differing profit margins across locations, depending on competition.
The law of one price for tradable commodities is an essential ingredient in the body
of knowledge known as international economics. Without the imposition of this
law, there would not even be the traditional "pure theory" of international trade.
Without this law, much of the "rnonetary theory," too, would have to be recon-
structed (Officer 1986, p. 159).

Similar statements can be found in Officer (1989) or more or less explidtly in almost
any international economics textbook (Appleyard and Field, Dunn and Ingram).
Rausser et al. implicitly assume that the LOP holds for primary commodities in
their modeling of the effects of monetary policy on agricultural prices. Another
argument (Baffes) is that modeling optimal intervention in a specific commodity
market---domestic or international--requires a representative price. If an inappro-
priate price is used, policy recommendations based on such a model might not
have the expected effects. Also, foreign prices are often assumed exogenous and
instantaneously reflected in domestic prices. Moreover, exchange rate changes are
assumed to pass through instantaneously to domestic prices (Chambers and Just).
On the other hand, "modern trade theory" economists suggest that numerous rea-
sons exist for the failure of the LOP. The reasons that received most attention among
very prominent trade economists are pridng to market (Dixit; Dombusch; Froot
and Klemperer; Kasa; Knetter 1989, 1993; Krugman 1987), exchange rate risk (Gio-
vannini), and geographical separation of markets including transportation costs
(Dumas, Krugman 1991b) and institutional factors that influence price settings in
128 Review of Agricultural Economics

different markets (Frankel, Stern, and Wei). Some other arguments focus on the
presence of nontradable inputs of production as a major reason for the failure of
the LOP (Frenkel, Giovannini, Kravis and Lipsey; Richardson). Ardeni argues that
costs of arbitraging can be high, at least for short periods of time, especially for
markets strongly influenced by intemational agreements. FinaUy, errors in data and
definitions of various prices is another explanation for some of the deviations. Pre-
suming that measurement errors are white noise, they should not alter long-run
tendencies and thus are nota valid explanation.
This article represents a critical review of recent literature related to the LOP in

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international trade. First, I look at the importance of the difference between the LOP
in the different markets within a country, the national market integration studies,
and the LOP in international trade. Then I give an account of the recent literature
on the LOP in the international trade of ag¡ commodities. Next I offer a
critical review of cointegration, the most frequently applied methodology employed
in recent LOP studies. The validity and appropriateness of both bivariate and mul-
tivariate cointegration are questioned. In the following section I discuss some of the
factors that prevent market arbitrage to force closer convergence of international
prices. This discussion includes the effects of transportation (transaction) costs, tar-
iffs, nontariff barriers, pricing to market, exchange rate risk, and trade regionaliza-
tion. Finally, I conclude with possible explanations for the volatility and persistence
of deviations from the LOP in international trade.

Does the Border Matter?

Historically, similar goods sold in different locations have different prices. The
infamous statement in Debreu says that goods are different if they are not sold in
the same place:
Finally wheat available in Minneapolis and wheat available in Chicago play also
entirely different economic roles for a flour mill which is to use them. Again, a
good at a certain location and the same good at a different location are different
economic objects, and the specification of the location at which it will be available
is essential. (pp. 29-30)

Only when costs are borne to transport wheat from Chicago to Minneapolis is the
Chicago wheat considered equivalent to the Minneapolis wheat. The question to
ask then would be, Is the failure of the LOP in international markets attributable
completely to the segmentation of markets by physical distances or does the pres-
ence of national borders separating locations play a role as well?
Indeed, some recent studies have shown that price differentials across countries
for very similar consumer goods, including food and beverages, are typically more
volatile than price differentials within a country for very dissimilar goods (Engel
and Rogers, McCallum, Mussa). The McCallum and Engel and Rogers papers look
at the U.S.-Canada regional patterns. They conclude that within a country, the rel-
ative price of the same good across two cities is a function of the distance between
them. They also conclude that a large difference exists in relative price volatility
when one compares two cities in different countries versus two cities in the same
country, even after controlling for distance. Thus, it follows that both distance and
border matter. They indicate that standard price-discrimination behavior involved
in cross-border price movements and nominal price stickiness account for some of
 The Law of One Price in International Trade 129

the price dispersion between markets. The price of a consumer good might be
sticky in terms of the currency of the country in which the good is sold. Goods
sold in the United States might have sticky prices in U.S. dollar terms, and goods
sold in Canada might have sticky prices in Canadian dollar terms. The nominal
exchange rate is, in fact, highly variable. In this case, the cross-border prices would
fluctuate along with the exchange rate, but the within-country prices would be
fairly stable. Standard price-discrimination behavior involved in cross-border price
movements is explained in the pridng to market literature (discussed later in this
paper). Other possible reasons that might explain why border matters so much

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include the importance of the informal trade barriers, homogeneity of productivity
shocks within countries in the nontraded factors, and the differences in demand
elasticities in the United States and Canada. Engel and Rogers also directly tested
for trade barriers and found that the size of the border coeffident was not dimin-
ished when the 1989 free trade agreement between the U.S. and Canada went into
effect. This still allows the possibility that informal trade barriers account for the
price dispersion. 1They also tested the hypothesis that labor markets might be more
homogeneous within countries, so that relative real wages are less variable for dty
pairs within a country than for cross-border pairs. Although they find, as expected,
that the wage dispersion coefficient 2 is generally positive and significant, the size
of the border coefficient is not much affected by inclusion of the wage-dispersion
variable. Thus, the border's importance does not arise because of homogeneity of
the labor markets within countries; however, the distance coeffidents are generally
smaller and less significant. Engel and Rogers believe that one of the reasons that
distance matters for intercity price dispersion is that more distant dties have less
integrated labor markets.
Engel tries to answer the question how volatile are deviations from the LOP
compared to the general variability of relative consumer prices within the economy
by looking at Canadian and U.S. data. Prices of a large number of goods, including
some agricultural and resource goods, and services are considered in his research.
He constructs forecast variances for relative prices on the basis of twelfth-order
autoregressions on the log levels of relative prices of a large number of similar
goods across borders and compares them with the volatility of relative prices of
dissimilar goods within a country's border. The forecasts were one-, three-, six-,
and twelve-month horizons. In most of over 2,000 pairwise comparisons, the rel-
ative price of very similar goods across the U.S. and Canada are much more volatile
than the relative prices of very different goods within either country.
It seems that among a group of agricultural economists a strong belief still exists
that LOP holds in spatially separated, international markets once prices are ad-
justed for exchange rates and transportation costs (Baffes; Goodwin 1992a, 1992b;
Goodwin, Greenes, and Wohlgenant). This might be coming from the interregional
(not intemational) trade models that deal with spatial market integration and in
which this type of "Samuelson's conjecture" is valid, that is, where market integra-
tion is achieved after accounting for the "iceberg type transportation costs." How-
ever, McNew indicates that "unlike the LOP, market integration is less clearly de-
fined and often based more on statistical criteria than on economic phenomena."
Studies by, for example, Sexton, Kling, and Carman, who developed a methodology
to test for effidency of interregional commodity arbitrage and applied it to U.S.
celery marketing, or Baulch, who developed the parity bounds model to determine
130 Review of Agricultural Economics

whether efficient arbitrage exists in the Philippine rice markets, are clearly studies
about (national) food market integration. Their findings and hypothesis are only
partially relevant references for the LOP in international trade studies. The evidence
about the importance of border in international trade is overwhelming, as discussed
previously, and it is clear that distance and transportation costs, after adjusting for
exchange rate, do not account for all the international price variability. After all,
the extent of a market as defined by Stigler and Sherwin implies either that a
product's prices in different geographical regions are approximately the same or
that they tend to move together. It is alear that this definition allows for existence

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of more than one market for a good and/or different prices of a good within the
same market. Moreover, Marshal (p. 325) wrote that "the more nearly perfect a mar-
ket is, the stronger is the tendency for the same price to be paid for the same thing
at the same time in alt parts of the market." Because it is recognized that intemational
markets are (generally) far from perfect (Frankel, Stern, and Wei; Knetter 1989;
Krugrnan 1987), it is unclear why imposing the LOP in international agricultural
trade modeling is so critical.

The LOP a n d I n t e r n a t i o n a l Trade of A g r i c u l t u r a l

Commodities and Food Products
A common belief has existed among economists for a very long period of time
that some agricultural goods that are highly traded, such as grains, do follow the
LOP. Empirical evidence from recent studies is mixed and does not support strong-
ly the LOP hypothesis. Methods they used in testing the LOP vary. The "conven-
tional treatment" in the past was commodity disaggregation combined with com-
parisons by means of ad hoc observations or simple correlation or regression anal-
ysis. Attempts were made to test the LOP using a breakdown of commodities at
an aggregation level no lower than that of tradables versus nontradables (Officer
1986). In other words, this type of test tested the law domestically, hypothesizing
that the prices of tradables and nontradables are equal and, internationally, hy-
pothesizing that the price of tradables is identical across countries. Goodwin, Gren-
nes, and Wohlgenant incorporated time lags in their model and used a generalized
method-of-moments econometric procedure to estimate rationally formed expected
future prices. Alternatively, they employed a nonparametric analysis of price parity.
In both cases they accounted for transaction costs. The most frequently used pro-
cedure in recent years has been cointegration, both bivariate and multivariate. Sec-
tion 4 discusses cointegration procedure in more detail.
Froot, Kim, and Rogoff look at the annual data on prices for grains (wheat, oats,
and barley), dairy products (butter and cheese), eggs, peas, and silver as well as
pound/shiUing nominal exchange rates in England and Holland over a period of
about 700 years, from 1273 through the early 1990s. Their finding is that the vol-
atility of deviations from the LOP for all goods has been very stable over the cen-
turies. This result appears to be robust to the choice of detrending methods and
to how one controls for the effects of plagues and wars. LOP deviations are highly
correlated across commodities (especially at annual horizons) and, for most pair-
wise comparisons in most centuries, at least as volatile as relative prices across
different goods within the same country. Thus, any explanation of this result might
not rely on institutional factors peculiar to the twentieth century; that is, their
 The Law of One Price in International Trade 131

analysis challenges the conventional view that the modern floating exchange rate
experience is exceptional in terms of the behavior of relative (exchange-rate ad-
justed) prices across countries.
Ardeni tried to verify the LOP focusing on a smaU number of commodities:
wheat, wool, beef, sugar, tea, tin, and zinc. The analysis was conducted for four
countries: Australia, Canada, the United Kingdom, and the United States. He used
quarterly data for export (import) prices adjusted for exchange rates for the time
period of twenty years: 1965 to 1985.3 Ardeni applied the Engle-Granger cointe-
gration procedure. Results of his study are quite unfavorable to the LOP. His con-

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clusion is that the LOP has held only for the following pairs of goods: U.S. wheat
(export price) and Australian wheat (import price), U.S. wheat (export price) and
Canadian wheat (export price), and U.S. tea (import price) and English tea (import
price); thus, the presumption that deviations from the long-run equilibrium are
transitory cannot be sustained. Thus, imperfect commodity price arbitrage for this
sample of goods appears to hold and confirms that exchange rates are not fully
transmitted to prices.
Another application of the Engle-Granger cointegration technique in attempt to
test the LOP is by Baffes. The LOP was tested for wheat, tea, beef, sugar, wool,
zinc, and tin for the United States, Canada, Australia, and the United Kingdom.
He dealt with 71 to 118 quarterly observations. The results of his study supported
the LOP for more than half the commodities under consideration. 4 Moreover, he
concluded that eventual failure of the LOP a s a long-run relationship is a price-
spedfic and time-period-specific problem rather than a general failure. He also
concluded that a possible reason for the LOP failure is transportation cost. Major
problem with Baffes's conclusions is that they are based on results that suggest a
negative relationship between prices. Cointegration can be consistent with a neg-
ative relationship between prices; however, the LOP suggests a positive correlation.
Zanias also used the Engle-Granger cointegration analysis to test the LOP asa
long-run relationship. The LOP is tested for four European Community (EC) prod-
ucts, namely, soft wheat, cows' milk, potatoes (main crop), and pig carcasses (grade
I) using between 60 and 132 monthly observations. His conclusion was that, at best,
the LOP appears valid in about half the combinations considered. Furthermore, he
concluded, in view of many obstacles to intra-EC trade, these results should not
come as a surprise, although it would be expected that the existence of common
intervention prices would tend to align prices more often. Zanias's conclusions are
flawed for the same reason that those of the Baffes study are: They are based on
results that indicate negative relationship between prices.
Goodwin (1992a, 1992b) used the Johansen's multivariate cointegration testing
procedures (the trace test and the maximal eigenvalue test) to evaluate the LOP for
prices in five intemational wheat markets. Monthly wheat price data cover the
period from January 1978 to December 1989. The results of his analysis indicate
that the LOP fails asa long-run equilibrium relationship when transportation costs
are ignored. However, when wheat prices are adjusted for freight rates, the LOP is
fully supported. His results indicate that a set of five international prices possess
only a single cointegrating vector in his analysis. That implies that any single price
can be solved for in terms of the other four prices. However, if a single price is
fully representative of the set of five prices, one would expect to find four cointe-
grating vectors.
132 Review of Agricultural Economics

Goodwin, Grennes, and Wohlgenant test the LOP for a number of oilseed prod-
ucts, wheat varieties, com, and sorghum monthly prices over a period of 72 to 128
months. The analysis includes various U.S. export markets and Japanese and Rot-
terdam import markets. They use two distinct procedures to testing the LOP. The
first approach uses the generalized method of moments econometric procedure to
estimate rationally formed expected future prices. Actual freight rates for wheat
trade are utilized to provide a proxy measure of transactions costs. A second ap-
proa& employs a nonparametric analysis of price parity using the actual freight
rates for trade between several important wheat markets. They conclude that using

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a simple expectations-augmented model produces greater support for the LOP than
the same model using contemporaneous prices. Only three out of seventeen com-
modity/market pairs that were analyzed violate the LOP. Thus, the LOP appears
quite strong in intemational markets for U.S. agricultural products.

Cointegration and the LOP

Cointegration means that although many developments can cause permanent
changes in two or more time series, some long-run equilibrium relation exists that
ties the series together, represented by their linear combination (Hamilton). One
way to formalize the idea of comovements among the prices of a same good in
different countries is to use the theory of cointegration. Tests for cointegration
developed by Engle and Granger and Johansen and Juselius found their almost
immediate place and became very popular method in the LOP studies. It was
argued (Ardeni, Goodwin 1992a) that conventional regression tests of the LOP
might have misrepresented or ignored the time-series properties of individual price
data series. Such properties might have important implications for statistical tests
of the LOP. In particular, ignoring serial correlation in an empirical test of the LOP
can yield inferential biases and inconsistencies. Furthermore, empirical tests that
use price differentials can suffer because such differencing transformations and
filters are ad hoc and might be inappropriate for a given price series.
As ah altemative, Ardeni, Baffes, and Zanias, among others, utilize the bivariate
two-step cointegration testing techniques of Engle and Granger. However, Goodwin
(1992a) recognizes that the cointegration tests of Engle and Granger are limited by
the fact that cointegration considerations are confined to pairwise comparisons and
because such tests require one of the two prices to be designated as exogenous.
Banerjee et al. have a concem about the potential for small-sample biases in param-
eter estimates obtained from such two-step procedures. Hall reminds us that Engle
and Granger's testing procedures do not have weU-defined limiting distributions
and, as a result, do not offer straightforward testing procedures. Thus, Goodwin
(1992a, 1992b) uses the multiva¡ cointegration tests (Johansen 1988, Johansen and
Juselius). These tests follow a maximum likelihood estimation procedure that pro-
vides estimates of all the cointegrating vectors existing among a group of variables.
Johansen's maximum likelihood approach uses test statistics that have an exact lim-
iting distribution that is a function of a single parameter and as such might be
advantageous when compared with the bivariate Engle and Granger procedure.
However, the existence of cointegration between (among) price variables does
not imply that the LOP holds, even after accounting for the transaction costs. Mas-
troyiannis and Pippenger argue that cointegration is a necessary but nota sufficient
 The Law of One Price in International Trade 133

condition for the LOP. To provide a more direct test of the LOP, Mastroyiannis and
Pippenger needed to show that the cointegrating vector between domestic and
foreign prices is unity. The implication of having a unity cointegrating vector is
that, in the long run, domestic and foreign dollar prices of the same commodity
are equal. If two series have unit roots and are cointegrated, an OLS regression of
one on the other is superconsistent. Standard t-tests that test the hypothesis about
statistical significance of estimated OLS coeffident are still inappropriate, but the
standard error of the estimates can be modified to yield a conventional t-test. The

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correction is developed in West.
Barrett states that cointegration is neither a necessary nora sufficient condition
for the LOP. If the transaction costs are nonstationary, failure to find cointegration
between two markets' price series can be completely consistent with the LOP, so
cointegration is unnecessary. He gives four reasons that cointegration is insufficient.
First, cointegration can be consistent with a negative relationship between prices
when the LOP or market integration suggest a positive correlation. That is rather
common appearance in the empirical studies (Baffes, Zanias). Second, the magni-
tude of the cointegration coefficients that is supposed to be informative about the
relative rates of change is often of a magnitude implausibly far from unity. Third,
market segmentation can result from either an absence of rational arbitrage o r a
rational absence of arbitrage, both implying an absence of effident exchange be-
tween markets. Cointegration tests identify only the first case. Finally, trade flows
are often temporally discontinuous because of perturbations and seasonal shifts in
underlying demand and supply patterns or in transaction costs. At these break
points, the slope of the relation between prices is zero, whereas at other times it is
roughly one. A s a matter of fact, the relation between market prices is of exactly
unit slope if transfer costs are purely additive. If some component is proportional,
they might differ from one. Where discontinuities exist, cointegration tests impose
a linear approximation to a nonlinear (piecewise linear) conditional expectation
function (McNew). The greater the transfer costs between markets and the more
frequent the discontinuities, the more pronounced this nonlinearity and the more
suspect the findings of linear cointegrating regressions.
The conclusion regarding cointegration as the methodology in LOP studies
would be that one should be very cautious when making inference on the basis of
its results. These studies do not tell us always about the condition of agricultural
markets. The practical importance of cointegration is notas a test for LOP in its
own right but a s a pretest for other econometric tests for LOP.

A F e w A n s w e r s to the Q u e s t i o n of Why the LOP Might Not

H o l d in I n t e r n a t i o n a l Trade
It is established up to this point that the LOP in international trade might not
hold. Several possible factors can distort convergence, most notably, (a) pridng to
market; (b) exchange rate risk, choice of currency denomination of export prices,
and price responses to exchange rate changes; and (c) effects of geographical sep-
aration of markets, including transportation costs, trade regionalization and other
institutional factors, tariffs, and nontariff barriers.
134 Review of Agricultural Economics

Pricing to Market
Export demand elasticities for most products vary by country. This provides the
impetus for the differential pricing of exports as opposed to price taking. This form
of imperfect competition in which exporters price discriminate across destination
markets and export prices depend on bilateral exchange rates is termed "pricing-
to-market~' (Krugrnan 1987).
Several theoretical models have been developed to consider price discrimination
over export destinations (Baldwin 1988; Dixit; Dornbusch; Knetter 1989, 1993). In
general, these models presume that price discrimination across destinations is pos-

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sible and proceed to analyze the response of traded goods prices to exchange rate
changes under constant marginal cost and altemative assumptions about market
structure (e.g., Cournot oligopoly, monopolistic price discrimination, or different
models of monopolistic competition). In each case, the response of import prices
to exchange rate changes ultimately depends on the convexity of the demand sched-
ule that individual sellers perceive themselves as facing. These models are devel-
oped as an answer to the observed insensitivity of dollar import prices to exchange
rates for a certain class of demand schedules in 1980s.
Knetter's model has been applied in agricultural economics to study the com-
petitiveness of U.S. export markets for wheat, feed grains, soybeans, soybean by-
products, and cotton (Park and Pick, Pick and Park). Pick and Park's results indi-
cated the presence of price discrimination by U.S. wheat exporters among import-
ing countries. However, they rejected the null hypothesis of price discrimination
across destination markets for cotton, corn, and soybeans. Their results were am-
biguous for soybean oil, cake, and meal. Yurnkella, Unnevehr, and Garcia identified
price discrimination for U.S. paraboil and long-grain-rice exports.

Exchange R a t e Risk
The effects of exchange rate risk on export prices and, to a lesser extent, trade
flows are widely ignored in empirical trade studies, although theoretical ground-
work has been laid down (Friburg, Giovannirª Johnson and Pick, Magee). Pick
addressed this issue in his study related to U.S. agricultural exports to seven de-
veloped and three developing countries. He determined that exchange rate risk
adversely affected U.S. agricultural exports to the developing countries. Anderson
and Garcia examined the effects of exchange rate uncertainty on bilateral soybean
trade between the United States and Japan, France, and Spain. Their finding is that
imports for these countries are sensitive to short-term variations in nominal bilat-
eral exchange rates. They also conclude that the effects vary across countries, de-
pending on access to forward markets, the availability of altemative soybean sup-
pliers, the degree of market concentration in domestic soybean processing sector,
and the degree of currency risk importers are willing to assume. Bahmani-Oskooee
and Ltaifa investigated the effects of exchange rate uncertainty on the aggregate
exports of nineteen developed and sixty-seven developing countries using cross-
sectional data. Exchange rate is found to be detrimental to the exports of both
developed and developing countries. However, developed countries' exports are
found to be less sensitive to exchange rate risk than those of developing countries.
Furthermore, within the developing countries, those who fixed their exchange rates
 The Law of One Price in International Trade 135

to one major currency were found to be subject to less risk than the other devel-
oping countries.
Some of the major findings in the theoretical studies cited previously regarding
the relationship of exchange rate risk and export prices are based on the assump-
tions of perfect intemational capital markets and risk-neutral firms and are as fol-
lows:
(a) When export prices are set in foreign currency, increasing exchange rate risk
leaves domestic and export prices unaffected; when export prices are set in

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domestic currency, increasing exchange rate risk has, in general, ambiguous
effects on the level of domestic and export prices.
(b) Third-currency (vehicle currency) pricing can be induced by the entry of a
competing exporter under imperfect competition. This is consistent with trade
in many primary commodities dominated by few exporters with many im-
porters but where commodities are not perfectly homogeneous.
(c) If profits are a concave function of the exchange rate, setting export prices in
foreign currency leads to higher expected profits. 5 If profits are a convex func-
tion of the exchange rate, setting export prices in home currency leads to higher
expected profits.
(d) The response of export prices to changes in the exchange rate arises from two
effects: an exchange rate expectations effect anda price discrimination effect.6
An increase in the price of a foreign currency that is expected to persist leads
to a fall in the export price quoted in foreign currency, and, under same reg-
ularity conditions, an increase in the export price quoted in domestic currency.
(e) When domestic and export prices are quoted in the same currency, any ob-
served deviations from the LOP indicate ex ante price discrimination; when
export prices are denominated in foreign currency, observed deviations from
the LOP are the sum of ex ante price discrimination and exchange rate "'sur-
prises."

Geographical Separation of Markets

Transportation costs have been generally recognized as an important factor in
the LOP studies and international trade modeling. Yet the literature on spillovers
and geographic concentration suggests that the effects of proximity on trade are
much greater than mere transportation costs. In the classic gravity model of world
trade, Linnemann concluded that the effect of distance on trade consisted of three
kinds of effects rather than one: (a) transportafion costs; (b) the time element in-
volving concerns of perishability, adaptability to market conditions, and irregular-
ities in supply in addition to interest costs; and (c) "psychic" distance, which in-
cludes familiarity with laws, institutions, and habits. When one adds to these the
significance of trade regionalization and formation of trading blocs along with the
adjoining issues of tariffs and nontariff barriers, the simplidty of the LOP concept
becomes rather questionable.
It is widely accepted that the first-best solution in international tracle would be
a worldwide regime of free trade in which all countries agree to refrain from
erecting barriers and an international institution exists to enforce the agreement.
However, this first-best is an ideal and is rather unlikely to be reached in practice.
136 Review of Agricultural Economics

Since its founding, the GATT has been predicated on the assumption of a second-
best regime, that is, in which each member accords others the status of most-
favored nation (MFN), or treats its trading partners equally. The GATT incorpo-
rated an important exception to the MFN principle in article 24: A subset of mem-
bers could form a free trade area (FTA), provided that certain conditions were met,
including that barriers within the FTA were removed completely and that barriers
against nonmembers not be raised. Theoretical arguments for the merits of article
24 are neither dear nor well established (Bhagwati; de Melo, Panagariya, and Rod-
rik). Nevertheless, the institutional support for violating the nature of an economic

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environment necessary for the very existence of the LOP is established. Some em-
pirical studies addressing the importance of trading blocs, trade regŸ
and their effects on intra- and interregional transportation costs and global (world)
economic welfare are listed in the following.
Krugrnan (1991a) supplied an argument against a world of a few trading blocs
in a model that assumes no transportation costs. He focused on the idea that when
individual countries forro larger groupings, they are liable to become more protec-
tionist and thus to move farther from the ideal of world free trade. The reasoning
was that a s a group they would set higher tariff levels in terms of the rest of the
world because they would have more monopoly power to exploit. Units were as-
sumed to set tariffs at a self-maximizing optimal level. His conclusion is that world
welfare is lower with a few trading blocs than with the extreme of only one. The
conclusion remained the same even after dropping the assumption of optimal or
endogenous tariffs (Krugman 1992). In another work, Krugman (1991b) reached a
different conclusion using a model that assumes prohibitively high transportation
costs between continents. He also concluded that even without the formation of
regional free trade areas or preferential trading arrangements of any sort, countries
trade more with their neighbors than with countries from which they are far re-
moved, partly because of transportation costs.
Frankel, Stern, and Wei use the gravity model to examine bilateral trade pattems
throughout the world. They find evidence of trading blocs (MERCOSUR in Latin
America and ASEAN) all around the world. Intraregional trade is greater than could
be explained by natural determinants: the proximity of a pair of countries, their size
and GNPs per capita, and whether they share a common border o r a common
language. They also analyze the more realistic case of trading blocs with intercon-
tinental transportation costs being neither zero nor so high as to be prohibitive. They
conclude that FTAs (both continental, or "natural," and intercontinental) leave ev-
eryone worse off than under MFN. Another welfare implication of the trade regŸ
alization is that partial liberalization within a regional preferential trading arrange-
ment (PTA) is better than complete (100%) liberalization. Finally, they estimate that
trading blocs on the order of European Union are in fact welfare reducing.
To summarize, all three of the previous arguments seriously question the validity
of the LOP in international markets. Serious consideration of these arguments is
necessary in any empirical work that atternpts to picture real-world international
trade. Intemational trade in agricultural commodities and food products should be
subject to the same rigorous analysis before reaching any conclusion.

Conclusion
The LOP in its simplicity has been capturing attention of economists for a long
time. It states that commodity arbitrage ensures that each good has a single price,
 The Law of One Price in International Trade 137

defined in a common currency unit, throughout the world. As such, it is also the
basic building block for any variation of purchasing power parity. In other words,
if market arbitrage enforces broad parity in prices across a sufficient range of in-
dividual goods (the LOP), a high correlation should exist in aggregate price levels.
It is traditionally assumed that primary commodities obey a perfect arbitrage
rule, with instantaneous and symmetric exchange rate pass-through. Many models
of international trade in agriculture are built on the basis of that assumption. As
muchas we would like to have an ideal world in which first-best would hold (i.e.,
free trade worldwide with perfect arbitrage in international markets), the real

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world deviates from this ideal. The empirical evidence does not fully support the
LOP. Many possible reasons exist for the deviations from the LOP, including pricing
to market, exchange rate risk, and geographical separation of markets.
Statistical estimates verifying the LOP might sometimes be questionable. Many
studies utilize techniques such as cointegration that by themselves cannot prove or
disprove the LOP. Using inappropriate methodology can create confusion among
professionals and lead to erroneous conclusions and policy-making decisions by
policy makers. Note that classical and neoclassical trade models rely heavily on the
LOP assumption:
The elasticities and other parameter values are the core of the behavioral responses
predicted by the trade models. Inaccurate measures of behavioral reactions to
changes in prices as embodied in biased price elasticities render unrealistic predic-
tions even if models are theoretically sound, data are accurate 7, and the solution
technique is mathematically sophisticated (Tweeten, p. 289).

Thus, a great deal of caution is necessary before making any conclusion or decision
regarding the LOP in any commodity market.

Acknowledgments
The author gratefully acknowledges the comments and suggestions of John Antle, Gary Brester, Barry
Goodwin, John Marsh, and Linda Young. However, the judgments made and errors that remain are
solely the responsibility of the author.

Endnotes
1 Examples illustrating the agricultural trade are health restrictions in trading live cattle or nonrecip-
rocal meat grading agreements with the United States and Canada.
2 Engel and Rogers construct a real wage as the average hourly wage for manufacturing employees
(which is available for each city in the United States and by province in Canada) divided by the aggregate
CPI for that city. They then calculate for each city pair the standard deviation of the two-month difference
in the log of the relative real wages and call it the wage-dispersion variable.
3 For some commodities, the sample started and ended a few quarters earlier (later).
4 Ardeni and Baffes used the same data set in their analysis but arrived at somewhat different con-
clusions. For an explanation on this issue, see Baffes (p. 1268
5 Giovannini and Baron show that concavity of profits with respect to exchange rate reduces to
concavity of the demand function with respect to the exchange rate if marginal costs are constant. With
linear demand and cost functions, quoting export price in foreign currency yields higher expected profits.
6 This result is due to Giovannini, who shows that comovements of prices of individual traded goods
and the exchange rate depend not only on demand and cost parameters but also on the stochastic process
followed by the exchange rate. He further shows that the stochastic properties of the deviations from
the LOP depend on ex ante price discrimination as well as on exchange rate surprises, which are due to
price discrimination.
7 The quality of the data used in these studies, although not specifically discussed in this article, is

another issue that cannot be ignored.

138 Review of Agricultural Economics

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