(c) R.D. Weaver 2004

Fundamental Analysis~Prices over space

Review & Application

(c) R.D. Weaver 2004

Local prices vary due to changes in determinants of…. Demand

For current use For storage (carry-out) For export

Supply From current production From storage (carry-in) From imports

(c) R.D. Weaver 2004

Two market model of price Goals

Be able to describe and characterize spatial structure of prices Be able to analyze & predict spatial variation in prices

What we need to know What are key drivers of price What relationships can we predict between key drivers and price?

Approach Graphics Algebra Implications

(c) R.D. Weaver 2004

Arbitrage: Two decisions to be made

Entry: Can a profit be made from arbitrage? Where to move the product?

These decisions determine Direction of trade flow

(import or export) (from to where?)

Volume of trade flow

Let’s ignore inventories for now!

(c) R.D. Weaver 2004

Building Spatial Arbitrage into the Market Local demand Local supply External Flow ~ the result of arbitrage

Imports Exports

Physical Balance Total Supply = Total Demand

Local supply + Imports = Local Demand + Exports

(c) R.D. Weaver 2004

Questions we need to answer:

How does this system determine prices?

Can we use it to analyze and predict price variation across geography?

(c) R.D. Weaver 2004

Price balances the market Local demand = some function of local price Local supply = some function of local price External Flow ~ the result of arbitrage

Imports = function of local price and external price Exports = function of local price and external price

Physical Balance Total Supply = Total Demand

Local supply + Imports = Local Demand + Exports

Total supply(local price, external price)

= Total Demand(local price, external price)

(c) R.D. Weaver 2004

How does it happen?

We know each market has

Demand (consumers)

Supply (producers)

But we need one more type of actor – arbitrager

What@#$^%?

(c) R.D. Weaver 2004

Arbitrage defined

In any multi-market setting, if prices provide an opportunity to profit from moving product from one market to another, someone will make that happen!

Arbitrage is the economic function of taking a product from a market where is has a low price to a market where the same product has a higher price that covers the cost and results in profit.

(c) R.D. Weaver 2004

How arbitrage links markets

Arbritragers link markets by forcing their prices into a fixed relationship

In a sense, with arbitrage the markets become one market, integrated by the efforts of arbitragers to make a profit from moving product from one market to another.

Spatial arbitrage is “trade” !

(c) R.D. Weaver 2004

Consider two markets ~ what to look for Without trade = autarky

Prices differ one market pays less than the other for the same product! Why?

With trade Prices are forced into a relationship by arbitrage such

that the difference is reduced to reflect only average arbitrage cost.

(c) R.D. Weaver 2004

What do you need to enable arbitrage?

(c) R.D. Weaver 2004

What do you need to enable arbitrage? Information

Technology (containers, refrig, etc.)

Transportation

Insurance

Financial services

(c) R.D. Weaver 2004

Graphically Market 1 without arbitrage

Market 1

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Quantity

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P1)

Local supply

Local demand

(c) R.D. Weaver 2004

Market 2 without arbitrage

-600 787.5 -480 79.697 51.842-550 725 -430 79.697 51.842-500 662.5 -380 79.697 51.842-450 600 -330 79.697 51.842-400 537.5 -280 79.697 51.842-350 475 -230 79.697 51.842-300 412.5 -180 79.697 51.842

Data used for graphics -250 350 -130 79.697 51.842Here, the inverse demand and supply functions are calced. -200 287.5 -80 79.697 51.842

Price Dependent Price Dependent -150 225 -30 79.697 51.842Market 1 Market 2 Market 2 -100 162.5 20 79.697 51.842Pd Quanitity Ps Pd -50 100 70 79.697 51.842

72 5 43.75 115 -25 68.75 95 79.697 51.84267 10 50 110 0 37.5 120 79.697 51.84262 15 56.25 105 25 35 52 79.697 51.84257 20 62.5 100 50 60 27 79.697 51.84252 25 68.75 95 100 110 -23 79.697 51.84247 30 75 90 150 160 -73 79.697 51.84242 35 81.25 85 200 210 -123 79.697 51.842

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(c) R.D. Weaver 2004

So, two markets different prices, what would you expect to happen?

(c) R.D. Weaver 2004

Two effects deserve consideration Prices will change

Quantity will shift from one market to the other What direction is the flow? How much? What determines the quantity

(c) R.D. Weaver 2004

Market 1

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Market 2

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Initially, P2>P1, what happens?

Only if P2 > P1 + AC12 would Y1 is arbitraged from Mkt 1 to Mkt 2

As product is moved from mkt 1 to mkt 2, P2 decreases and P1 increases, why?

(c) R.D. Weaver 2004

Market 1

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What happens to prices?

What happens to quantities?

(c) R.D. Weaver 2004

Market 1

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Note: at the new prices one market has “excess supply”

And one has “excess demand”

Together, excess supply = export to mkt 2 = import mkt1 = excess demand

(c) R.D. Weaver 2004

Market 1

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Initially, P2<P1, what happens?

Only if P2 + AC21 < P1 would Y be arbitraged from Mkt 2 to Mkt 1

As product is moves, P2 increases and P1 decreases, why?

(c) R.D. Weaver 2004

Result: Geography of price

Economic theory tells us Direction of flow from one market to another How prices will be related ~ spatial structure of prices

(c) R.D. Weaver 2004

Effects of TradeImporting region’s

price is reduced as “imports” expands total supply = domestic supply + imports

Exporting region’s price is increased as exports reduce total supply = domestic supply - exports

Markets are linked >changes in exogenous factors in exporter market affect changes

in importer market price>changes in importer market change exporter price

Price differences between regions are reducedSpatial structure in prices is created

(c) R.D. Weaver 2004

Benefits of trade

Trade and arbitrage integrates markets that are spatially separated.

Reducing price in the high price market Increasing price in the low price market

Arbitrage brings goods otherwise not available into the high priced market, increasing the standard of living…..

Arbitrage increases prices in the low price market, providing increased demand, employment, driving wages up.

(c) R.D. Weaver 2004

Trade: What function in decentralized markets? Allocation of scarce products to locations where

they have the highest value Equalization of prices across markets ensures

everyone faces the same value of scarce resources