(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

(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 Local supply Local demand

(c) R.D. Weaver 2004 Market 2 without arbitrage

(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 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 What happens to prices? What happens to quantities?

(c) R.D. Weaver 2004 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 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 Trade Importing 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 reduced Spatial 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