How Markets Become Efficient (Part I)
Take a seat. Suppose you import chairs from Mexico and you have the following costs and profit expectations: It costs you $15 per chair for manufacturing in Mexico and delivery to your store in the US; your overhead per chair in the U.S. is $10, and you sell the chairs here for $60 each in two month’s time.
Your cost per chair is $15 (manufacturing and delivery costs) + $10 (overhead) = $25 (your investment). Your net proceeds per chair are $60 (sales proceeds) – $25 (costs) = $35 (profit), which you attain in two month’s time; so your return is one-half of $35/$25, or one-half of 140%, which equals 70% per month–a handsome return indeed, especially if you can ratchet up production and move volume.
| If you have a very high return opportunity, you can increase your return by selling the opportunity to another trader… |
Now suppose you discover you can sell your chairs to a retailer who will pay you only $45 per chair, but who also will reduce your holding time to one month and absorb half of your overhead costs. The retailer will, of course, sell your chairs for the same $60 amount and take $15 of your previous $35 profit. The retailer’s investment per chair is $45 (to you) + $5 (overhead) = $50; his per chair profit is $60 – $50 = $10, and his return will be one-half of $10/$50, or one-half of 20%, which equals 10% per month–not as high as your former return, but still attractive enough to entice him into the arrangement.
What is your return now? Your manufacturing and delivery costs still total $15, but you now have only $5 holding costs, giving you a total investment of $20. Your profit is now $45 – $20 = $25 per month, and your return is now $25/$20 = 125% per month, a substantial increase from your previous return of “only” 70% per month.
You have moved from a return of 70% per month to a return of 125% per month by sharing your profit with the retailer, whose incentive is the 10% per month that he earns by paying you a lower price than you could obtain yourself.
| …who also will earn a decent return (but not as high as yours). This is one of the ways markets become efficient |
The “hand-off” principle. These numbers are fabricated, but the principle is not. The principle: If you have a very high return opportunity, you can sell that opportunity to another market participant who will also earn a decent return (although not as high as yours), and consequently increase your own return. This happens in the market all the time.
It describes, in fact, one of the basic mechanisms through which a market becomes efficient. This “handing off” of opportunities by market players with high return to players who are happy with a lower but still acceptable return occurs in markets all the time. It has occurred in the options markets since their inception and it is occurring today. More on this in the next commentary.