How does arbitrage affect price determination in competitive markets?

Arbitrage influences price determination in competitive markets by ensuring prices remain consistent and fair across different markets.

Arbitrage is a fundamental concept in economics and finance, referring to the practice of taking advantage of a price difference between two or more markets. Traders who engage in arbitrage, known as arbitrageurs, buy a product in a market where the price is lower and sell it in a market where the price is higher. This process continues until the price difference (or the arbitrage opportunity) no longer exists.

In competitive markets, the law of one price should theoretically hold. This law states that in the absence of trade frictions, a good should sell for the same price in all locations. However, in reality, prices can vary due to factors such as transportation costs, taxes, and tariffs. Arbitrageurs exploit these price discrepancies to make a profit, and in doing so, they help to equalise prices across different markets.

When arbitrageurs buy low-priced goods in one market, they increase the demand for the good in that market, which pushes up the price. Conversely, when they sell the goods in a higher-priced market, they increase the supply of the good in that market, which drives down the price. This process continues until the prices in the two markets converge. Therefore, arbitrage plays a crucial role in ensuring that prices in competitive markets reflect the true value of goods and services.

Moreover, the possibility of arbitrage ensures that prices in competitive markets respond quickly to changes in supply and demand conditions. If a sudden increase in demand leads to a price rise in one market, arbitrageurs will immediately start buying the good in other markets where the price is lower and selling it in the high-priced market. This will increase the supply in the high-priced market and reduce the supply in the low-priced markets, causing the prices to converge.

In conclusion, arbitrage plays a vital role in price determination in competitive markets. It ensures that prices remain consistent across different markets and respond quickly to changes in supply and demand conditions. Without the process of arbitrage, price discrepancies could persist, leading to inefficiencies in the allocation of resources.