Global Prices in a Free Market

by | Sep 8, 2022 | Economics, WORLD

In a free market, there is a tendency toward the establishment of a uniform price for the same good throughout the world.

A second principle of price determination, similar and closely related to the uniformity-of-profit principle, and which also plays a major role in coordinating the division of labor, is that in a free market there is a tendency toward the establishment of a uniform price for the same good throughout the world.

The basis of this principle is the fact that any inequality in the price of the same good between two markets creates an opportunity for profit. In order to profit, all one need do is buy in the cheaper market and sell in the dearer market. The very fact of doing this, however, acts to reduce the inequality in price. The additional buying raises the price in the cheaper market and the additional selling lowers it in the more expensive market. The process tends to continue until the inequality in price between the two markets is totally eliminated and a uniformity of price is achieved.

The reason that uniform prices among different geographical markets are not actually established is mainly the existence of transportation costs. The existence of these costs means that before a price discrepancy between two markets becomes profitable to exploit, it must exceed these transportation costs. These costs, however, then set the limits that geographical price discrepancies do not tend to exceed. Or, to put it positively, the price of the same good tends to be uniform throughout the world except for transportation costs between markets. (In the case of goods sold by a single seller, such as those with brand names or under patent protection, the principle may take the form that the wholesale price in the market that imports tend not to exceed the retail price in the market that exports, plus transportation costs. So long as the good is publicly available to all comers at the retail level in any given country, its wholesale price in a free market cannot for long be greater elsewhere by more than the costs of transportation. Thus, for example, in a free market, while American pharmaceutical manufacturers might charge less for various patented drugs in Mexico than in the United States, because of the lower incomes and thus smaller demand for drugs in Mexico, they would not be able to do so for very long by more than corresponded to this variant of the principle.) The significance of the principle of the tendency toward a geographic uniformity of prices is very great. Its operation explains, for example, why local crop failures in a free market do not result even in significant scarcities, let alone famines. The effect of a failure of the local grain crop, say, is to begin raising the price of grain in the local market. Once the local price of grain exceeds prices in outside markets by more than transportation costs, it becomes profitable to buy in those outside markets and sell locally. The effect is that the reduction in the local supply is almost entirely made good by drawing on the production of the rest of the world. Consequently, instead of a disastrous reduction in the local supply and an enormous rise in the local price, there is a modest reduction in the world supply and a modest rise in the world price of grain.

A good analogy to what happens is provided by the physical principle that water seeks its level. Imagine that you have just filled an ice tray—the kind in which water is able to flow around and underneath the plastic or metal insert that marks off the separate compartments for the ice cubes. If you now remove water from one compartment of the tray, you will not reduce the water level in that compartment by the amount of water you take from it. You will reduce the water level in that compartment and in the whole tray very slightly, because the loss from the one compartment will be spread over the whole tray. In just the same way, if half the wheat crop of France were lost, the supply of wheat in France would not fall by half. On the contrary, the supply in France and in the whole world might fall by 2 or 3 percent—or however much of a decline the French loss represented in the world supply.

Water seeks its level by virtue of the force of pressure. It moves from places of higher pressure to places of lower pressure. Commodity supplies seek their level by virtue of the attraction of profits. They move from places of lower prices to places of higher prices, in the process equalizing prices as the movement of water equalizes pressure.

It should be realized that the principle of the tendency toward a geographical uniformity of prices is not only descriptively analogous to a law of physics, but, as far as the ability of governments to act is concerned, has the same existential status as a law of physics. (And so, incidentally, do all the principles of economics.) That means it is impossible even for the world’s most powerful governments to annul its operation. Governments can frustrate its operation, but even in the cases in which they do so, they cannot annul its operation. The existence of the principle is confirmed by the very attempts to frustrate it, because to frustrate it, definite means must be adopted, which are necessary only because the principle exists, and is working. For example, governments may adopt tariffs, or they may prohibit imports or exports altogether, and in that way stop the equalization of prices. But why must they resort to such measures? The answer is because the principle does exist and is at work even in a controlled economy. Controls of a specific kind are needed to counter it. There is no difference here between economics and the example of water seeking its level. We can make ice trays in which each compartment is totally insulated from the others. That does not contradict the principle that water seeks its level. It confirms it, because the insulation is required only because water does seek its level, and for some reason one wishes to stop it from doing so. It is the same way with all economic laws and government attempts to frustrate them.

Adapted from Reisman’s Capitalism: A Treatise on Economics, Chapter 6, The Dependence of the Division of Labor on Capitalism, “2. The Tendency Toward a Uniform Price for the Same Good Throughout the World.”

George Reisman, Ph.D., is Pepperdine University Professor Emeritus of Economics and the author of Capitalism: A Treatise on Economics. See his author's page for additional titles by him. Visit his website and his blog Watch his YouTube videos and follow @GGReisman on Twitter.

The views expressed above represent those of the author and do not necessarily represent the views of the editors and publishers of Capitalism Magazine. Capitalism Magazine sometimes publishes articles we disagree with because we think the article provides information, or a contrasting point of view, that may be of value to our readers.

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