The Illusion of Perfect Competition: The Law of One Price under Trading Frictions

Abstract

Perfectly competitive behavior can occur in individual markets that should not be competitive if only analyzed in isolation from the wider economy. To show that, I study an economy where consumers and workers have imperfect access to the firms, and these frictions imply that firms have market power in the labor and product markets. Suppose frictions are higher in the labor market than in the product market. In that case, the firms behave competitively in the product market: frictions in the labor market prevent the firms from altering supply to the degree required to exploit their market power.

Keywords: Frictions of trading, competition, law of one price, price dispersion

JEL Classification: D21, D41, D43