Question

2. Suppose the law of one price does not hold between Japan and China because the Yuan (Chinese currency) price of a digital camera sold in Japan is higher than the price of the same camera sold in China. If we assume that there are no transportation costs or barriers to trade between the two countries, then:

a. the Japanese traders will want to sell cameras in China.

b. the Japanese will want to buy cameras from China.

c. the Chinese will want to buy cameras from Japan.

d. the price of cameras in Japan will increase.

e. the price of cameras in China will fall.

Answer 1

Considering that the Law of One Price doesnot hold between Japan and China, the price of a digital camera will be different in the two countries when exchange rates are taken into consideration.

This means that there exists an arbitrage opportunity. This means that traders of these countries can use the price difference to their advantage.

Now since the price of the digital camera is lower in China, the Japanese traders would want to buy the cameras from China and sell it in Japan and earn higher profit margin. Hence option "b" is the correct option.

Also, to be noted here is, over the long run, due to continuous arbitrage by traders, eventually the prices of digital cameras in both countries will reach equilibrium. That means prices price of cameras in Japan will fall, while that in China will increase.