CHAPTER 4

Noise Traders and the Law of One Price

One of the very first things a student learns in beginning economics is that if two commodities are identical, then they will command identical prices in the marketplace. If the price of the two commodities should ever diverge, buyers will buy the cheaper of the two, and sellers will sell the more expensive of the two, pushing the divergent prices toward each other. It is likely that someone will try to buy the commodity in the cheap market and sell it in the more expensive market and earn an arbitrage profit. Thus, the law of one price emerges: two identical commodities must have the same price almost all the time.

THE LAW OF ONE PRICE AND THE CASE OF FUNGIBILITY

All of this seems simple enough, as long as we are comfortable with the definition of identical. What if two things are identical, but we refer to them by different names? Are they still identical? Do they still command the same price in the marketplace? Imagine a factory that produces baseballs. Suppose that every second baseball produced is called a hardball, whereas all others produced are called baseballs. But suppose in every respect there is absolutely no physical difference between a hardball and a baseball. They are the exact same thing except for their differing names. Can a hardball have a different price than a baseball? (See Figure 4.1.)

Figure 4.1 Can These Two Have Different Prices?

The two items above are not strictly identical because they have different ...

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