Theoretical Description and Empirical Evidence over the Validity of Ppp and the Law of One Price as Its Building Block Essay

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CARDIFF BUSINESS SCHOOL | PURCHASING POWER PARITY AND THE LAW OF ONE PRICE |

Against all odds
Despite being severely criticised for more than three decades the Purchasing Power Parity and its building block - the Law of One Price still play vital role in economics

Introduction
Would you believe in the law of gravity if quite often objects that should stay firmly on the ground were instead flowing weightlessly in the air even though they were not supposed to? Probably not. However, if physicians were economists they would simply attribute it to a marginal error in their calculations and still accept it as a valid law. Among the considerable amount of examples the Purchasing Power Parity (PPP) and its building block – the Law of One
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A significant amount of empirical research has been done on the validity of the Law of One Price (LOP) and although called a law, it has probably been violated more than any other economic law (Miljkovic, 1999). Authors have found the LOP to hold among some products and not others (Ardeni, 1989; Baffes, 1991; Zanias, 1993). Other authors have questioned the testing techniques used (Pippenger, 2004; Goodwin 1990; Goodwin, Greenes, Wohlgenant, 1990). Further down few key empirical studies will be presented with their findings and conclusions. Due to the vast amount of research on the topic this essay does not claim being either fully comprehensive nor very detailed as its aim is to give rather good idea about the main problems regarding PPP and its foundation – the Law of One Price.
Empirical evidence on LOP
Early empirical literature on the validity of the law of one price finds little support in favour of the hypothesis. In recent years, however, evidence coming from the exploitation of new data sets, either in the form of panel data or longer time series data, tend to support the view that the law of one price does hold in the long run (Goldberg and Verboven, 2005; Cecchetti, Mark, and Sonora, 2002). The documented price convergence in the European car market during the integration process is one of the few pieces of evidence that are in