Tuesday, January 14, 2014

How entrepreneurs use Arbitrage and how Government destroys it

Arbitrage is the capitalization of spreads in the markets. The spread is the price difference of the same item. A seller can buy and sell the same item for a profit. The process normally starts with the seller making an offer/asking price to sell the good. A potential buyer may bid on the price or haggle. There are many scenarios to explore which gives keen insight to how markets behave.

Free market economy scenarios

1. A merchant sees that consumers in town are buying milk for $5 per gallon. He stopped by a farm and was able to buy them for $0.50 per gallon. The next day he sold milk at the town for $4.50 per gallon to beat the competition. The spread declines due to increasing competition.

2. In hopes in repeating the success, the merchant goes to the farm to buy more milk. Due to shortages they are now charging $1.00 per gallon. He decides to purchase them since the profit is still attractive. Customers came to his shop again, but the majority only offered $4.00 below his asking price. Since diary spoils, he had to sell it or risk losing inventory. As a result, the drop in demand and higher cost lower his profits.

3. The next day, customers began lining up at the merchant's shop. Fortunately, the other stores stop selling milk because they decide it wasn't worth it. Customers were willing to pay $7 per gallon. The profit increase as demand rises and competitors drop off.

In a free market economy, the market spread expands and contract within reason. All prices are justified through the choices of buyers and sellers. The merchant was rewarded because of the work he put in. His competitor gave up profits, because they weren't willing to do it anymore. There are no exceptions.


Government interference scenarios

4. Due to reckless spending, the government need funding by imposing higher income tax for small businesses. The farm increase the cost of milk and the merchant did not want to earn less because of the government's reckless spending so he increased the price of milk to $9 per gallon. The consumers did not like this.

5. After many complaints about the price of milk from low income families, the government on election year issued subsidies for milk to low income families. All the other merchants decided to carry milk again and sets the asking price at $11 per gallon. The low income families paid the asking price without issue as it was free money. The higher income families than not like this, since they are now paying a higher price, and could not bargain due to the other consumers.

6. After more complaints on high milk prices, the government place a $5 per gallon cap on milk. The merchant closed his milk business and pursues more profitable alternatives.

Government regulations will cause abnormal market spreads as it limits the choices of the individual. The merchant must adjust the price due to government factor and not market factor. We can see how prices can suddenly inflate due to stimulus and taxation. It is always the case.




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