Tuesday, November 16, 2004

Arbitrage

A take home test question in one of my four classes concerns the term arbitrage. In the text for the course the term is defined as "buying low and selling high".

Essentially arbitrage involves buying an item at a low price in one market and selling it at a higher price in another market. One of the roles of an entrepreneur is to identify items that are relatively scarce in one market (and hence have a high price) but are abundant in another market (as reflected by a lower price in that market). The arbitrageur then buys the product in the market with the low price and re-sells it in the market with the higher price. Obviously, this will increase the demand for the product in the lower priced market causing the demand curve to shift to the right and the price to rise. In the higher priced market the increased supply of the product that results from the entrepreneur or arbitrageur's action will cause the supply curve in that market to shift to the right causing the price in that market to fall. Eventually the two prices will converge and the price will be the same in both markets.

For arbitrage to take place there must not be any insurmountable barriers to the transaction. For instance, fresh lobsters are cheaper in the coastal areas of Maine than in Arizona. Restaurant owners in coastal Maine simply go to the dock and buy the lobsters from the returning fishermen. In Arizona the lobsters have to be packed and flown across the country causing the price to be considerably higher. But an arbitrage opportunity does not exist because the price difference is due to the shipping costs which cannot be avoided.

Generally, arbitrage opportunities arise due to lack of easy access to information and markets. But once these are overcome opportunities for arbitrage appear.

A decade ago the market for antiques and collectables was fragmented and localized. Potential sellers tended to be individuals with limited information about the market and too few items to justify the time and expense to seek out buyers for their items. Buyers also tended to be small collectors with limited resources. Enter eBay. With a few keystrokes and payment of a very nominal fee, sellers could advertise their wares to the world. With the same few keystrokes and no monetary cost, buyers could literally search the world for the items they desired. Prices were determined by demand and supply in this world wide market and everyone had immediate access to the latest price information in the market. Thousands of people found that items cluttering their homes were fetching high prices in other parts of the country and, for a nominal fee to eBay and a small shipping expense, they could reap a large profit on these previously "worthless" items. The result was an explosion in antiques and collectables with people first selling the accumulated clutter in their own homes and then, the more enterprising ones, branched out and began shopping garage sales, estate sales, local antique shops and auctions seeking items that could be sold for higher prices in other areas. It didn't take long for everyone to learn about eBay and the opportunities for profit. Today, most arbitrage opportunities in this market are gone as the market done its job of transmitting information and eliminating price differences between different areas for the same items.

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