The Special Case of Purchasing-Power Parity
A famous hypothesis in economics, called the law of one price, states that the same
good cannot sell for different prices in different locations at the same time. If a
bushel of wheat sold for less in New York than in Chicago, it would be profi table
to buy wheat in New York and then sell it in Chicago. This profi t opportunity
would become quickly apparent to astute arbitrageurs—people who specialize
in “buying low” in one market and “selling high” in another. As the arbitrageurs
took advantage of this opportunity, they would increase the demand for wheat
in New York and increase the supply of wheat in Chicago. Their actions would
drive the price up in New York and down in Chicago, thereby ensuring that
prices are equalized in the two markets.