On June 25th, 2019, rapper Travis Scott announced a collaboration with Reese’s Puffs cereal, selling limited-edition boxes for $50. That price seemed ridiculously high to me. I wouldn’t pay $5 for cereal, let alone $50. Joke’s on me though, because they sold out in less than a minute. The next day they were up on eBay for anywhere between $100 and $400. Think of the margin on a single box of cereal–ridiculous! But actually, unbeknownst to the resellers, this process, formerly called arbitrage by economists, is actually good for the market.
Arbitrage is when an entrepreneur, also known as a middleman, finds an underpriced good, such as football tickets or a limited edition cereal. They buy that good on the cheap, turning around and selling it at a price reflecting their expectations about demand—ideally, a higher price. This process drives the market closer to equilibrium. Prices get driven higher and higher until they either find the equilibrium price and sell at a profit or overpay and take a loss. Really, it’s just a gamble that the entrepreneur knows the market better than the original seller.
Think of it as the starter game of The Price is Right. Everybody tries to bid as close to the number as possible, but if their bid is above the price, they’re out of the game. As each participant ups their bid, the winner ends up with a number close to the right price.
We tend to look down on those who work with arbitrage, or middlemen. These middlemen we see as people who take a good selling for cheap and sell it to us for more than it’s “worth”. When I see scalpers outside of football games selling tickets at a higher price, sometimes I find myself sticking my nose up at them. But the thing is, they’re actually a benefit for the market and the public.
So why is arbitrage good for the market?
First, it’s one of the factors leading markets to more closely reflect theories on paper. Arbitrage is one of the reasons prices aren’t arbitrary. For instance, one of the most famous economists, Adam Smith, praised the middleman for his arbitrage. Those who speculate predict that demand will create a scarcity. If they’re wrong, they take the losses on themselves and have to sell at a lower price closer to equilibrium. If they’re right, they get to sell at a profit and resolve shortages by moving prices closer to the equilibrium price. These middlemen take on the risk of loss, in hopes to earn profits for themselves. This process helps to resolve frictions in the market.
Second, arbitrage frequently overcomes barriers. Travis Scott announced the sale in a pop-up event in Paris. Then he sold them on his website. Neither of those are really accessible to the majority of the public. But entrepreneurs brought these goods from those lesser known venues to bigger websites like eBay or Amazon. This seems more trivial now, but before the internet this process was essential. Men speculating the demand in different markets is the difference between a community getting access to goods and not.
These middlemen don’t charge for more than what the product is worth. They’re trying to find exactly how much the product is worth and sell it to you at that price. I see people upping my price for a box of cereal, but they just might be the only reason I see that box of cereal for sale at all.
These middlemen are an essential part of our world that push us closer to a more perfect economy. Despite my initial reaction, those eBay salesmen have taken on a noble task. They improve the market for Reese’s Puffs boxes with a picture of a rapper on them. Okay, maybe I’m making this a little more dramatic than it is. But regardless, middlemen get rid of shortages and improve market forces. Respect the hustle.