Arbitrage and pricing
Tags: Arbitrage, Pricing, Rewards, Risk

Reward comes with risk. Yes comes with a no and success comes with chances of failure…

Does it mean you shouldn’t go for opportunities which apparently have only success as a outcome? Well, Arbitrage is a concept fairly popular in finance and even more so in our life although in a transient manner and success without chances of failure is exactly what it is.

What’s Arbitrage and why does it exist? If I had to put in a sentence, it exists because market forces operate with a lag. For instance, if you discovered (by chance or your sheer hard work) a magical potion which increases one’s age by 10 years or so. Now how do you price it? We’ll understand pricing of your potion and in the process see what arbitrage really is.

A product can be priced using following methods:

Cost based pricing- Calculate how much it costed to come up with that product. For instance, how do you price a car(let’s say a Hyundai verna): Well, we simply add up cost of material, cost of goods, cost of human resources employed across the value chain and then we add margin over it and divide it per unit, roughly speaking, to obtain price of the car.

Value based pricing: Price the product or service based upon the value it generates for you. For instance, how much should one pay to a maid who cooks food, does laundry everyday. Well, we start by thinking what would have happened if the maid wasn’t there. Probably you wouldn’t be able to continue with my job. Does it mean if one earns salary of Rs 30,000 per month, all of it should be attributed to maid if they hire one and continued with job. Well, certainly not. At Rs 30,000 they would be indifferent to work and no work in monetary terms but for all the load and stress of work and also the efforts one has put in the past to get that job, one’d certainly need to have more for themselves after deducting maid’s salary? How much?

5000(Maid’s salary= 25,000)??? Well certainly no. You put in too much for your job everyday for 5 days a week, 4 weeks a month.

10000(Maid’s salary = 20,000)?? No.. it is still way too low. Also, you have to make up for the cost of education you have gone through and the loans you have taken. So certainly not.

15000(Maid’s salary = 15,000)? One might have agreed but wait. There is too much of uncertainty in this life. What if something happens to you someday and you are no longer employable. No, you’d need more.

Skipping few steps

35,000(Maid’s salary=0)? Well, one would be happy but obviously no maid works for no salary. Besides they too have a family to take care of.

33,000(Maid’s salary=2,000): Looks fine maybe.

We can go on like this and try finding precise figure but that’s not the scope of this article and there is nothing called precise price. What maid would demand is a entirely different matter but I hope we are clear how value based pricing works.

Competitor based pricing: You try and find out how much other families are paying their maid and pay accordingly.

Just knowing there are different methods of pricing an offering isn’t enough if we do not know when to use which. I chose maid example for the value based pricing and a car example for cost based one and it wasn’t just random. There is some rational to what to use when but I’ll skip that for now.

Now getting back to where I had diverted from. Why do arbitrages exist? Because pricing done using either of the above method is just the beginning. What eventually moves the price is supply and demand forces. These are the market forces which occur with a lag and hence arbitrage occurs until market forces sets in fully.

Going back to your potion which you have developed, you may price it using one of the above methods (Value based pricing looks more suitable here, though) and figure out there is a tremendous demand for your potion. You will subsequently have to increase the price to match increasing demand and even further or maybe reduce it based upon how demand holds up. Now before things settle in, there will be a very dynamic phase. Let’s see what’s happening in between.

You have decided to expand your potion in various geographies and since it is a valuable one you have priced it at premium depending on how wealthy the nation is. Lets say you price it like this: India — Rs 20,000 for one litre; Rs 5,000 in Ghana; Rs 1,00,000 in US. Now a businessman named Mr. Arbit Rage(don’t miss to notice what the name sounds like) got interested in your product and wanted to come up with a similar product but fails owing to lack of technical competency. Fortunately he finds another way of making money through your product. What if he buys your product from Ghana and sells it in US and India. Difference in price offsets more than price of airfare and other costs. He is making money without taking any risk of failure. Because of this there will be increased demand of potion in Ghana as a part of it is being diverted to other countries like US and India. Parallelly, there will be reduced demand in US and India as there is additional supply from the businessman other than what you were already supplying directly. In this case you will have to increase the price in Ghana so that supply equals demand. Similar thing would happen in US and India where prices would have to be dropped and supply reduced. Eventually a point will be reached where no such arbitrage exists across geographies and Mr. Arbit would be forced out of business (before of course making loads of money). This would be a steady state and dynamism would reduce significantly. SO not confuse steady state with steady prices. Steady state here refers to supply forces being in equilibrium with demand forces unlike earlier where there was extraneous factor induced by Mr Arbit. Post steady state, prices would move solely on the basis of supply and demand of that particular geography and not due to any other external factor.

With more than 300 generations having survived on this planet and enormous amount of global trade that has already taken place, scope of arbitrage has come down with each generation solving problems and bringing in efficiency wherever they could through reduced information asymmetry via knowledge creation, knowledge sharing etc. Hence always look out for possibility of arbitrage in businesses just like Mr. Arbit Rage was for they are a rarity and they’ll not exist forever.