{"id":780,"date":"2020-07-31T23:30:49","date_gmt":"2020-08-01T03:30:49","guid":{"rendered":"http:\/\/commoncents.blogwyrm.com\/?p=780"},"modified":"2023-05-06T16:52:18","modified_gmt":"2023-05-06T20:52:18","slug":"market-inefficiencies-and-arbitrage","status":"publish","type":"post","link":"https:\/\/commoncents.blogwyrm.com\/?p=780","title":{"rendered":"Market Inefficiencies and Arbitrage"},"content":{"rendered":"

Arbitrage: it isn\u2019t an often-heard word when discussing the economy.\u00a0 In fact, I consulted the indices of 6 textbooks in economics, covering micro or macro or both, and ranging from mostly qualitative to strongly mathematical, and found not a single entry; but its importance to markets can be hardly overstated.\u00a0 In order to understand why this is, we need to first think a little about how markets work and the role of information in the marketplace.<\/p>\n

A key observation is that markets work most efficiently when they are at a natural equilibrium, and their approach to equilibrium or even the equilibrium they assume can be impeded by insufficient information about the goods and services being sold.<\/p>\n

For example, in Chapter 18 of his book Principles of Economics: Economics and the Economy Version 2.0<\/em>, Timothy Taylor discusses how imperfect information can impede economic participation in each of the markets for goods and services, labor, and finance.\u00a0 A person seeking to buy a used car is naturally wary about the quality of the car, about which they know very little and the seller knows far more.\u00a0 An employer looking to hire a new employee is also naturally wary about the quality of the employee, because all that he can discern comes from a r\u00e9sum\u00e9 and an interview.\u00a0 (As a side note, this is why the coding interview, in which prospective computer programmers are given real problems to solve, exists as a hiring gate.)\u00a0 Finally, a person seeking a loan from a bank has to contend with the bank\u2019s inherent skepticism about the soundness of their repayment prospects, even if the person has an impeccable character where borrowing money is concerned.<\/p>\n

These reluctances serve to slow down economic participation, push the equilibrium away from where it would sit in a market with perfect knowledge, and can lead to unintuitive situations where raising prices can actually raise demand rather than the other way around (that, however, is a post for another day).\u00a0 Collectively, economists term all these \u2018non-ideal\u2019 market behaviors as inefficiencies.<\/p>\n

A sad but powerful example of the kind of havoc uncertainties can wreak is summarized in Jamie Goldberg\u2019s article Downtown Portland businesses, derailed by pandemic, say protests present a new challenge<\/a><\/em>.\u00a0 In the article, Goldberg quotes Andrew Hoan, president and CEO of Portland Business Alliance, as saying of downtown Portland:<\/p>\n

It\u2019s unique, it\u2019s boutique, it has the best of all kinds of experiences for customers and for employees and for employers, and it\u2019s devoid of that now because of the uncertainty.<\/div>\n

Markets have developed lots of different ways of dealing with inefficiencies and the risks that follow.\u00a0 Some of the more well-known ones are guarantees, certifications, and insurance and premiums.\u00a0 Interest rates on loans are structured to provide the lender some insurance against the default of the loan as seen in the usual formula:<\/p>\n

Interest Rate = Risk Premium + Expected rate of inflation + Time value of money<\/div>\n

The last two terms collectively account for the simple fact that a dollar spent today provides more utility than a \u00a0dollar spent tomorrow because 1) inflation eats away at the purchasing power of money (\u2018Expected rate of inflation\u2019 term) and 2) the enjoyment derived from a good or service is less when one has to wait for it (\u2018Time value of money term representing delayed gratification).\u00a0 Since both of these effects are known beforehand, they attach to any transaction.\u00a0 The first term (\u2018Risk Premium\u2019) represents all of the uncertainty brought on by the lack of knowledge about the transaction (does the good have high quality? is the borrower going to pay it back? and so on).<\/p>\n

The mechanism of arbitrage<\/a> is another powerful way for the markets to deal with some of these inefficiencies by making it profitable for traders to equalize information between all parties.\u00a0 It just isn\u2019t as broadly familiar.<\/p>\n

In a nutshell, arbitrage is the purchase and subsequent sell of some good (typically called an asset) in order to profit from a positive difference between the final market\u2019s price and the asset\u2019s price in the original market.<\/p>\n

In theory, the exercise of arbitrage offers zero risk because the resell is instantaneous and the receiving market can accommodate the amount being resold.\u00a0 In reality, nothing is truly risk free, and a number of complications can arise that blunt the attractiveness of arbitrage.<\/p>\n

For example, suppose that bananas sold for $1.00\/pound in Joe\u2019s Market but $1.40\/pound in Fred\u2019s Market elsewhere in town.\u00a0 Then a person can possibly make money by purchasing a supply of bananas at Fred\u2019s and transporting them to Joe\u2019s market.\u00a0 In this fashion arbitrage eliminates or, at least, helps to lessen imbalances in the economy caused by a lack of information (since if shoppers knew they could get bananas cheaper at Joe\u2019s than Fred\u2019s they would, all other things being equal, shop for bananas at Joe\u2019s).\u00a0 Arbitrage also facilitates a better match between supply and demand, again smoothing out imbalances caused by lack of information and other factors.\u00a0 However, it is important to realize that arbitrage is distinct from distribution by a middle man even if they share some aspects.<\/p>\n

\"\"<\/a><\/p>\n

Many real world factors contribute to making this typical introductory example more complicated than it might seem at first glance.\u00a0 The primary complication is that the time needed to purchase, transport, and subsequently resell the goods must make it worthwhile engaging in this form of arbitrage.\u00a0 The profit earned on the resell must be great enough to outweigh the transportation cost, regulatory fees, and the opportunity costs in order for people to engage in it.\u00a0 These barriers are why we don\u2019t typically see parties engaged in retail arbitrage.<\/p>\n

As the internet-of-things has made the flow of information incredibly easier, it is now possible to find people talking about their retail arbitrage efforts moving product from brick-and-mortar shops for resell on Amazon and Ebay.<\/p>\n