December 19th, 2014
Arbitrage is the act of moving things from a place where they’re less valuable (cheaper, if you like) to where they’re more valuable (more expensive).
Normally the term is used in financial transactions – if a ton of wheat is worth $200 in Chicago and it’s worth $250 in Houston, I can buy it in Chicago, sell it in Houston, and make money. That’s arbitrage.
But – that’s just a financial manipulation; a trick played with numbers to cheat the system. I haven’t really created anything or done anything useful.
Tho it may seem that way, not right. Economics is not intuitive.
Suppose I have a pile of wood. It has some value. I get tools, work hard with them, and turn the wood into a house.
(If you’re outside America, assume a pile of stones – I know you people think making houses out of wood is crazy.)
The house is worth a lot more than the wood pile was.
This also is arbitrage. We don’t usually call it that, but it is – I’ve moved the low-value wood in such a way that it’s now a high-value house.
Yes, I used capital (the tools) and labor (the work) to do it, but that’s how I did it – not what I did.
This is where all wealth comes from – moving things around from less-valuable conditions into more-valuable conditions.
Capital and labor and technology are useful only when they help with arbitrage (digging holes and filling them up again uses labor, and shovel-capital, and scooping-technology – but doesn’t create any wealth).
Another example – when I was in kindergarten, sometimes I’d get sent with a salami sandwich (this was before in-school cafeterias). I didn’t love salami – I preferred tuna. But a friend had a tuna sandwich, and preferred salami. We’d swap. (Yes, I know that’s not allowed anymore.)
By swapping, we turned two not-highly-valued sandwiches into two more-valued sandwiches – because we each preferred the other’s sandwich. The sandwiches remained exactly the same. But the value increased – by arbitrage.
Back to the ton of wheat in Chicago. Let’s ask why wheat is cheaper in Chicago. There must be a reason, even if we don’t know what it is. Maybe there was a bumper wheat harvest in Illinois (where they keep Chicago), so there’s more than people can eat. Maybe they like rice better. Whatever.
In Houston – the opposite. Maybe there’s a pizza holiday that uses up lots of wheat. Or a bad harvest in Texas…again, whatever.
The point is, by moving the wheat from Chicago to Houston, I’m moving it from where it’s needed less to where it’s needed more – afterwards, there is less excess wheat in Chicago (and more valuable money), and less shortage in Houston. So I made both places better off.
Which means it was not a trick – I really did do something useful. I created wealth. And some of that wealth I get to keep (some will go to the seller in Chicago, and some to the buyer in Houston – exactly how much depends on negotiating skills, buy/sell spreads, etc.).
So arbitrage is where all wealth comes from. It is the sole reason we don’t live in caves anymore.