Narrator: Listen to part of a lecture in an economics class.
Professor: One of the most interesting aspects of international trade is the pricing of goods and services in different places. Has anyone heard of the Big Mac Index?…Yes, a few of you? This is a clever index, published by The Economist magazine, that shows how much a McDonald’s hamburger costs—depending on exactly where you are buying it. It sounds silly, but actually there’s a very important macroeconomic principle behind it.
That principle is called the Law of One Price. Basically, this “Law” states that a product must sell for the same price in different locations… once the exchange rate, um… is taken into account. But that’s not what the Big Mac Index shows. Last time I checked, the spread in prices worldwide was substantial. Would you believe, if you bought a Big Mac in, say, Switzerland, you would have to pay more than four times what you’d pay in Egypt? Again, adjusting for exchange rates… but… how–how can this be? Well, if… if the Law of One Price actually held, then it couldn’t. So let’s talk about where the “Law” comes from, and what factors can cause it not to hold.
First, let’s talk about arbitrage. Yes, this is a fancy word. People on Wall Street love to use it. But “arbitrage” means something very simple—it means “an opportunity to make a profit without taking any risk.” Much of economic theory is built on the idea that arbitrage opportunities don’t exist. Or, that if they do, buyers and sellers will move quickly to extract that profit from the marketplace. If the Law of One Price does not hold, someone could make a riskless profit by buying in one location and selling elsewhere.
So, can you “arbitrage” a Big Mac? Do you want to buy a Big Mac in Egypt, then fly to Switzerland and find a buyer there? Of course not. The flight alone would be too expensive. But maybe corporations could do so? Well, if it were that easy, wouldn’t McDonald’s already be doing so? Or someone else?
Clearly, that is one reason why the Law of One Price doesn’t hold. For most products, the situation is this: it’s a useful theory to help explain the long-run balance in the worldwide market for a tradeable product, but often in the short term it does not hold. And there are reasons why it may never hold.
The first reason, as you might have deduced from my example, is shipping costs. The Law of One Price assumes no shipping costs, and… no trade barriers. Well, first, there’s the Mediterranean Sea between Egypt and Switzerland. Then, you have to find a way up the mountains of Switzerland to find your Big Mac buyer. And you have to do all this nearly instantly, before the Big Mac goes bad. So there goes the theory of no shipping costs!
Another reason is that some goods are not tradeable. Here’s an example. Can you export a haircut? Think about it… How would you sell a haircut to someone many kilometers away? You can’t. And this is true of all services—unless they can be done remotely, say over the telephone, or internet… there, uh… there’s no way to sell that service to someone elsewhere. Think about dry cleaning, or window repair, or performing marriage ceremonies—you can’t ship these services, so you can’t trade them. And when a product can’t be traded, the Law of One Price may not hold.
Want another asset that’s not tradeable? Land. Land cannot be shipped elsewhere. And some land—some real estate—is much more valuable than others. This is a big reason why Big Macs are more expensive in Switzerland than many other places. It’s like in certain cities, like New York and London—real estate is extremely expensive, because the demand to live or work there is very high, while the supply of land is never really going to increase. And when you’re talking about nearly any product, real estate costs will factor into the price of any goods sold there. You have to lease or buy the land for the restaurant that serves the Big Mac, right? You also must pay people more money to live in an expensive town to sell those Big Macs. And you must store some of the ingredients, in freezers or refrigerators or warehouses, located on or near this expensive land.
Um, it’s interesting to note that there’s one more reason why the Law of One Price may not hold… that is imperfect information. This comes up in economics all the time. The point is that if producers are unaware of customers in other places that are willing to pay more for a product—or if buyers don’t know about cheaper ways to buy the product elsewhere—then the Law of One Price can be violated indefinitely. This used to be a much bigger issue, but with communication capabilities today, it’s becoming less and less important.
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What is the talk primarily about? |
Gist-content. The lecture primarily focuses on the Law of One Price, and reasons why it may not hold in the real world. |
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| ✓ | A Explaining an economic theory that frequently proves to be inaccurate |
Correct. In the lecture, the professor notes many reasons why the Law of One Price may not hold. |
| ✗ | B Exploring ways to make a riskless profit through international trade |
The professor explains that arbitrage means a way to make a profit without taking any risk. But the professor does not explore ways to do so. |
| ✗ | C Discussing the pricing of the Big Mac sandwich |
This example is used heavily at the beginning of the lecture to explain the Law of One Price, but it is not the primary focus of the lecture. |
| ✗ | D Providing information about how services can be traded internationally |
The professor only discusses services specifically to point out that many of them cannot be traded across long distances. |
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What does the professor imply about possible reasons why Big Macs sell for a higher price in Switzerland than in many other places? |
Inference. According to the lecture, selling Big Macs in areas where real estate is expensive increases the price of Big Macs. Additionally, high shipping costs can prevent prices in different locations from converging. Both of these factors imply that Big Macs may remain more expensive in Switzerland than in other locations. |
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| ✗ | A There is a high demand for Big Macs among Swiss citizens. |
The professor does not mention anything about Swiss citizens having a high demand for Big Macs. |
| ✗ | B Switzerland is close to Egypt. |
If anything, the professor implies the opposite: there are physical barriers between Egypt and Switzerland, and these barriers prevent prices from converging. |
| ✓ | C Real estate in Switzerland is expensive. |
Correct. The professor states: “Land cannot be shipped elsewhere. And some land—some real estate—is much more valuable than others. This is a big reason why Big Macs are more expensive in Switzerland than many other places.” |
| ✗ | D Switzerland lacks some materials needed to make Big Macs. |
This idea is not mentioned in the lecture. |
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According to the professor, what is a reason that services often violate the Law of One Price? |
Detail. The professor makes it clear that the Law of One Price applies in the long-run to tradeable products only, and that many services cannot be traded long distances. |
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| ✗ | A Most services are granted using a barter system, with prices that vary from country to country. |
This idea is not mentioned in the lecture. |
| ✓ | B Many services are difficult to trade across long distances. |
Correct. Because these services are difficult to trade over long distances, pricing differentials are difficult to exploit, so they can persist. |
| ✗ | C Services often require raw materials that are expensive to purchase. |
This idea is not mentioned in the lecture. |
| ✗ | D Some services can be provided over the telephone or internet. |
It is implied that this is a reason why some services may adhere to the Law of One Price, rather than violate it. |
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What does the professor imply about the prices of goods sold in New York and London? |
Inference. The professor compares Switzerland to New York and London—two cities with very high real estate prices—to explain how high real estate costs can affect the prices of goods sold there. |
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| ✓ | A They are likely to be higher than in most other places. |
Correct. This is implied as a result of real estate being expensive in both cities. |
| ✗ | B They are likely to be similar to those in Egypt. |
This idea is not mentioned or implied in the lecture. |
| ✗ | C They are likely to be higher in New York than in London. |
This idea is not mentioned or implied in the lecture. |
| ✗ | D They are likely to be equal to the prices found in other major cities worldwide. |
The professor does not discuss other major cities worldwide. |
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What does the professor imply about trade barriers? |
Inference. The professor states: “The Law of One Price assumes no shipping costs, and… no trade barriers.” The implication is that trade barriers can cause the Law of One Price not to hold. |
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| ✗ | A They allow international prices for a product to converge. |
If anything, the professor argues that the opposite is true—trade barriers can interfere with the Law of One Price. |
| ✓ | B They can cause the Law of One Price to be violated. |
Correct. The professor states that the Law of One Price assumes no trading costs and no trade barriers. This implies that trade barriers can cause the Law of One Price not to hold. |
| ✗ | C They reduce the cost of shipping internationally. |
This idea is not mentioned or implied in the lecture. |
| ✗ | D They are usually implemented for political reasons. |
The professor does not discuss or imply anything about why trade barriers are implemented. |
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What is the professor’s viewpoint regarding the accuracy of the Law of One Price? |
Speaker’s Attitude. The professor makes it clear that the Law of One Price often does not hold, especially in the short term. |
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| ✗ | A It is a helpful method for finding the average price of a product worldwide. |
This idea is not discussed in the lecture. |
| ✗ | B It is an effective way to generate arbitrage opportunities. |
The professor states that if the Law of One Price holds, then no arbitrage opportunities will exist. |
| ✗ | C It is accurate in most cases. |
The professor claims that the Law of One Price holds for some products in the long run, but it’s frequently wrong for a number of reasons. |
| ✓ | D It holds in certain circumstances, but there are many reasons why it will never hold for some products. |
Correct. According to the professor, the Law of One Price is useful for understanding pricing tendencies in the long run, for certain products, under a series of conditions. |