1. (c) R.D. Weaver 2004 In the real world, what are the drivers of spatial arbitrage? Adding some reality

2. (c) R.D. Weaver 2004 Drivers of spatial price structure If two markets are integrated by arbitrage, then  Demand and supply drivers in source market affect price as do drivers in the destination market.  But what else? We need to consider drivers of arbitrage!  In a purely open economy setting, with not distortions or barriers to trade, what would be involved?

3. (c) R.D. Weaver 2004 Adding reality …..and complications there are some important factors that affect arbitrage  Time costs  Product Deterioration/Quality Change  Transport costs  Expected price  Currencies differ  Exchange rate risk  Access to markets These drive a greater wedge between prices….

4. (c) R.D. Weaver 2004 Recall the simple case Arbitrage forces prices into an equilibrium relationship!

5. (c) R.D. Weaver 2004 Let’s add the easy complications first….  Cost of moving the product (transport, insurance, handling,….) C ij (Y ijt )  Product Deterioration/Quality Change d ij  Expected price P e it Define arbitrage profits π ijt = P e it d ij Y ij - P jt Y ijt + C ij (Y ijt )}

6. (c) R.D. Weaver 2004 Time costs…. Time costs (interest on …..) add these into costs C ij (Y ijt ) = (1+r t ){P jt Y ijt + C ij (Y ijt )} Define arbitrage profits π ijt = P e it d ij Y ij - (1+r t ){P jt Y ijt + C ij (Y ijt )}

7. (c) R.D. Weaver 2004 Implications of the easy complications first…. Competition drives arbitrage profits  π ijt = P e it d ij Y ij - (1+r t ){P jt Y ijt + C ij (Y ijt )} = 0 P e it d ij = (1+r t ){P jt + AC ij (Y ijt )} P e it = (1+r t ){P jt + AC ij (Y ijt )}/ d ij So, interest rates, transport costs, and physical deterioration are drivers of spatial arbitrage & thus impact prices!

8. (c) R.D. Weaver 2004 Do interest rates really affect spatial arbitrage? Typical food product spends more than 2 weeks in the “pipeline”.  What value of product does Kraft have stuck in the pipelines of spatial distribution?

9. (c) R.D. Weaver 2004 Trade Arbitrage Equilibrium Case 2: Different currencies (we’ll ignore d and r for now) Define exchange rate E ij = units ith cur/ units jth cur yen/$ What is $100 worth in the EU? Euros = (Euros/$) $100 73€ = 0.73 * $100  Exhange rates are the price of a currency …in terms of another currency….

10. (c) R.D. Weaver 2004 Exchange rate exercises A shirt in Germany has a price of 38€  $ ______ A McDonald’s double cheese in Paris is 8€  $ ________

11. (c) R.D. Weaver 2004 Exchange rates vary

12. (c) R.D. Weaver 2004 Even in the shorter-term

13. (c) R.D. Weaver 2004 But compared to interest rates?

14. (c) R.D. Weaver 2004 Trade Arbitrage Equilibrium Case 2: Different currencies (we’ll ignore d and r for now) Define arbitrage profits (in exporter cur, e.g. yen) = E ij P e j Y- P i Y-C ij (Y) > 0 = (yen/$) * ($/box)*boxes-(yen/box)*boxes-yen cost Arbitrage equilibrium if E ij P e j - P i -C(Y)/Y = 0  E ij P e j = P i + AC(Y i,j )

15. (c) R.D. Weaver 2004 Trade Arbitrage Equilibrium Case 3: Taxes and subsidies Suppose importer charges import tax (T i ) Suppose exporting country pays subsidy (S i ) Arbitrage if exporter profits > 0 π ijt = E ij P e it (1-T j ) d ij Y ij - (1+r t ){P jt (1-S it ) Y ijt + C ij (Y ijt )} >0 E ij P e it (1-T j ) d ij =(1+r t ){P jt (1-S it ) + AC ij (Y ijt )} P e it =(1+r t ){P jt (1-S it ) + AC ij (Y ijt )}/ E ij (1-T j ) d ij

16. (c) R.D. Weaver 2004 Bottomline P e it =(1+r t ){P jt (1-S it ) + AC ij (Y ijt )} / E ij (1-T j ) d ij Drivers of prices include those affecting arbitrage Exchange rates Interest rates Taxes and subsidies Transport and cost of logistics Physical deterioration

17. (c) R.D. Weaver 2004 Implications Prices are bound together by spatial arbitrage But, arbitrage itself has drivers!  Interest rates  Deterioration rates  Taxes and subsidies  Exchange rates  Logistic technologies  cost

18. (c) R.D. Weaver 2004 Exchange rate distortion Governments can distort exchange rates  Fixing them overtly (Chinese won 30/$1)  Fixing them through currency market actions US Treasury prints and sells $ to reduce value of the $ US Treasury buys T-bills and other $ obligations  $ into world mkt  reduced value of $ US Treasury buys $ Why would a government do this?

19. (c) R.D. Weaver 2004 Purchasing power parity and cultural convergence: evidence from the global video games market Joe Cox disparity between official market exchange rates and the real rates of exchange between two currencies is measured using local prices of video game consoles.

20. (c) R.D. Weaver 2004 Marketing margins vary over time Due to……. Changes in region or location drivers Deterioration of product Exchange rates Taxes & subsidies Transport and transaction costs  Fuel  Interest rates  Wage rates

21. (c) R.D. Weaver 2004 Why might wages and other input prices matter? Reason 1 Recall, Ac ij is the average cost of transfer. if any price that affects that transfer cost changes, trade flows and the resulting price structure will be affected! Examples: diesel fuel price, insurance rates, port labor rates

22. (c) R.D. Weaver 2004 Conclusions: Spatial price structure 1) Prices are linked across space A change in one market will affect other markets  Keep an eye on related markets & regions! 2) We can use spatial price structure to analyze prices and marketing margins Suppose you operate a feed mill producing commercial feed. Where will you buy grain?

23. (c) R.D. Weaver 2004 A few readings A hungry dragon A hungry dragon Does the world have enough resources for China to keep growing at its present pace? (From The Economist print edition) Sep 30th 2004 China's insatiable appetite for raw materials China's insatiable appetite for raw materials Nowhere is the impact of China's growth clearer than in the world's commodity and raw materials industries. No industries will lose more if that growth slows (From The Economist print edition) Feb 19th 2004