(c) R.D. Weaver 2004

In the real world, what are the drivers of spatial arbitrage?

Adding some reality

(c) R.D. Weaver 2004

Drivers of spatial price structure If two markets are integrated by arbitrage, then

Demand and supply drivers in source market affect price as do drivers in the destination market.

But what else?

We need to consider drivers of arbitrage! In a purely open economy setting, with not distortions

or barriers to trade, what would be involved?

(c) R.D. Weaver 2004

Adding reality …..and complicationsthere are some important factors that affect arbitrage Time costs

Product Deterioration/Quality Change Transport costs Expected price Currencies differ Exchange rate risk Access to markets

These drive a greater wedge between prices….

(c) R.D. Weaver 2004

Recall the simple case

)(

0)(/

0)(

_

)(

1212

12121212

1212112212

1212112212

YACPP

YACPPY

YCYPYP

entryfreearbitrage

YCYPYP

Arbitrage forces prices into an equilibrium relationship!

(c) R.D. Weaver 2004

Let’s add the easy complications first….

Cost of moving the product (transport, insurance,

handling,….) Cij(Yijt)

Product Deterioration/Quality Change dij

Expected price Peit

Define arbitrage profits

π ijt = Peit dij Yij- Pjt Yijt + Cij(Yijt)}

(c) R.D. Weaver 2004

Time costs….

Time costs (interest on …..) add these into costs

Cij(Yijt) = (1+rt ){Pjt Yijt + Cij(Yijt)}

Define arbitrage profits

π ijt = Peit dij Yij- (1+rt ){Pjt Yijt + Cij(Yijt)}

(c) R.D. Weaver 2004

Implications of the easy complications first….

Competition drives arbitrage profits

π ijt = Peit dij Yij- (1+rt ){Pjt Yijt + Cij(Yijt)} = 0

Peit dij = (1+rt ){Pjt + ACij(Yijt)}

Peit = (1+rt ){Pjt + ACij(Yijt)}/ dij

So, interest rates, transport costs, and physical deterioration are drivers of spatial arbitrage &

thus impact prices!

(c) R.D. Weaver 2004

Do interest rates really affect spatial arbitrage? Typical food product spends more than 2 weeks in

the “pipeline”. What value of product does Kraft have stuck in the

pipelines of spatial distribution?

(c) R.D. Weaver 2004

Trade Arbitrage Equilibrium Case 2: Different currencies (we’ll ignore

d and r for now) Define exchange rate

Eij = units ith cur/ units jth cur yen/$

What is $100 worth in the EU? Euros = (Euros/$) $100 73€ = 0.73 * $100

Exhange rates are the price of a currency …in terms of another currency….

(c) R.D. Weaver 2004

Exchange rate exercises

A shirt in Germany has a price of 38€

$ ______

A McDonald’s double cheese in Paris is 8€

$ ________

(c) R.D. Weaver 2004

Exchange rates vary

(c) R.D. Weaver 2004

Even in the shorter-term

(c) R.D. Weaver 2004

But compared to interest rates?

(c) R.D. Weaver 2004

Trade Arbitrage Equilibrium Case 2: Different currencies (we’ll ignore

d and r for now)

Define arbitrage profits (in exporter cur, e.g. yen)

= Eij PejY- Pi Y-Cij(Y) > 0

= (yen/$) * ($/box)*boxes-(yen/box)*boxes-yen cost

Arbitrage equilibrium if

Eij Pej- Pi-C(Y)/Y = 0

Eij Pej = Pi + AC(Yi,j)

(c) R.D. Weaver 2004

Trade Arbitrage Equilibrium

Case 3: Taxes and subsidies Suppose importer charges import tax (Ti )

Suppose exporting country pays subsidy (Si )Arbitrage if exporter profits > 0

π ijt = Eij Peit (1-Tj) dij Yij- (1+rt ){Pjt (1-Sit) Yijt + Cij(Yijt)} >0

Eij Peit (1-Tj) dij =(1+rt ){Pjt (1-Sit) + ACij(Yijt)}

Peit =(1+rt ){Pjt (1-Sit) + ACij(Yijt)}/ Eij (1-Tj) dij

(c) R.D. Weaver 2004

Bottomline

Peit =(1+rt ){Pjt (1-Sit) + ACij(Yijt)} / Eij (1-Tj) dij

Drivers of prices include those affecting arbitrage Exchange rates Interest rates Taxes and subsidies Transport and cost of logistics Physical deterioration

(c) R.D. Weaver 2004

Implications

Prices are bound together by spatial arbitrage

But, arbitrage itself has drivers! Interest rates Deterioration rates Taxes and subsidies Exchange rates Logistic technologies cost

(c) R.D. Weaver 2004

Exchange rate distortion

Governments can distort exchange rates Fixing them overtly (Chinese won 30/$1) Fixing them through currency market actions

US Treasury prints and sells $ to reduce value of the $ US Treasury buys T-bills and other $ obligations $ into world

mkt reduced value of $ US Treasury buys $

Why would a government do this?

(c) R.D. Weaver 2004

Purchasing power parity and cultural convergence:evidence from the global video games marketJoe Cox

disparity between official market exchange rates and the real rates of exchange between two currencies is measured using local prices of video game consoles.

(c) R.D. Weaver 2004

Marketing margins vary over timeDue to……. Changes in region or location drivers Deterioration of product Exchange rates Taxes & subsidies Transport and transaction costs

Fuel Interest rates Wage rates

(c) R.D. Weaver 2004

Why might wages and other input prices matter? Reason 1

Recall, Acij is the average cost of transfer.

if any price that affects that transfer cost changes, trade flows and the resulting price structure will be affected!

Examples: diesel fuel price, insurance rates, port labor rates

(c) R.D. Weaver 2004

Conclusions: Spatial price structure1) Prices are linked across space

A change in one market will affect other markets

Keep an eye on related markets & regions!

2) We can use spatial price structure to analyze prices and marketing margins

Suppose you operate a feed mill producing commercial feed. Where will you buy grain?

(c) R.D. Weaver 2004

A few readings

A hungry dragonDoes the world have enough resources for China to keep growing at its present pace? (From The Economist print edition) Sep 30th 2004

China's insatiable appetite for raw materialsNowhere is the impact of China's growth clearer than in the world's commodity and raw materials industries. No industries will lose more if that growth slows (From The Economist print edition) Feb 19th 2004