Sunday, 16 June 2013

Arbitrage

Been to your local supermarket recently?

You'll see signs along the lines of, "You can only buy six cans of infant milk powder". In our local store, you can buy precisely one tin of goat milk infant formula at a time.

I can be convinced otherwise on the facts, but usually I (and, I'd like to think, most market-friendly economists) have to be dragged kicking and and screaming to subscribe to a "market failure" explanation of anything. Markets are normally very good at solving allocation problems. So this (on a normal reading) is a rather bizarre outcome. You can buy tins of baby milk powder at your local supermarket, send them off to friends and rellies in North Asia, and make a profit.

Arbitrage - the process that says, the same things out to cost the same everywhere, net of transaction costs - isn't working effectively. Well, it is to some partial extent - obviously, people are swooping on their their local supermarket to clear the shelves of stuff that is valued more highly elsewhere. But they have not succeeded in fully closing the price difference.

Why is this happening?

Three thoughts.

First, the person in the street doesn't normally find these sorts of arbitrage opportunities. You can imagine smart financial institutions, for example, exploiting minute differences between the forward price of the Swiss franc in different marketplaces. But you don't expect big opportunities on your local high street, where anyone can put a jar in a bag and post it off for a profit. From that alone, you can infer - and without subscribing to the know-nothing 'markets don't work' view - that there is something strange going on in this market. Something on the supply side of the market doesn't seem to be responding to high demand.

Second, why do the supermarkets care? Why are they doing this? If I was running a store, and there was massive demand for one of the products I stock, I would be saying to my wholesaler, I'll take everything you can send me. I wouldn't be rationing it (let alone rationing it in such an easily circumventable way). I'd be saying, come here and fill your boots.

Maybe there's some sort of social responsibility thing going on - if we send all the baby formula up to Asia, what will Kiwi kids live on? - or some sort of resistance to setting  a market-clearing price on the shelves (fear of being perceived as profiteering?), or, more plausibly, it could be that stores don't like to have empty spaces on the shelves. When one of your selling points (as against, for example, the standalone butcher or greengrocer) is that you've got a full range, it's not great to have a big blank on the baby food shelves. You'd think that the supermarkets have every incentive to sell as much as they can, if they can get hold of it.

Three, however you get there, you are left with the idea that there is an extremely lucrative market in Asia, that local suppliers have been slow to capitalise on. There could be good reasons for this, and usually when you look at any reasonably competitive market, your best bet is that businesses do what they do because it's the most efficient thing to do. It could be (for example) that existing capacity is tied up with long-term contracts that don't easily accommodate diversion of production to new markets that have proved to be extraordinarily profitable.

On the other hand, I've just read that Fonterra is taking on the contract manufacturing work for Heinz's infant formula brands, as it wasn't cost effective for Heinz to keep on manufacturing them in the UK and shipping them from there to China. That doesn't sound like there's a capacity problem.

So, you wonder. If you and I can make a quick buck sending milk powder north, why aren't we seeing the big players coming in and doing it for themselves?

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