Market inefficiency, arbitrage and brand strength

Insights from Covid-19

“People in markets find a way of getting down to the essentials of I have, you want; you have, I want.”
― Audre Lorde, Sister Outsider: Essays and Speeches

All markets go through a journey of inefficiency to efficiency. When the market for a certain product is nascent, it is likely to be inefficient. However, it matures over time. The inefficiency could be thought of as demand and supply sides going through a courtship period — both the fair price and the availability of the product is still being discovered. As demand and supply become more stable, the market moves towards efficiency. More and more users can expect to buy the product at roughly the same price, and suppliers can plan their production with reasonable accuracy to minimize both stock-outs and overstocking. Markets for toothpaste, running shorts, pyrex containers, etc. are some examples.

As markets become efficient, the business moves away from players who participated and thrived in the inefficient market. Players, more adept at creating efficient markets emerge, and are able to grow the market significantly. This in a way is the transition from eBay to Amazon. eBay was the reason the markets for many products got created online; Amazon formalized them and made them efficient.

⬅️ Return to Market inefficiency

While there is always scope of markets to become more and more efficient, it is rare for markets to return to their previous state of inefficiency. However, Covid-19 made that happen. I was recently looking for a webcam; I read reviews and found certain models of Logitech to the best but they were sold out online everywhere except for on eBay. I finally bought a new one on eBay at a 50% markup! I was playing in an inefficient market.

Fig: Market dynamics and opportunities

In efficient markets, the % of “end user” purchases in a certain range (say +/- 10%) of a given (retail) price stabilize at a very high level; by “end user” purchases, I mean the purchases made by users who are buying the product for their own or their friend/family use, and not for reselling. However, during Covid-19 induced shock, some product categories were pushed into an inefficient market phase.

During this time, the % of “end user” purchases at the retail price actually dipped, with purchases at much higher prices making for a bigger share than usual. This happened because a sudden increase in demand for certain products created an arbitrage opportunity which some people were very ready to capitalize on. They bought these products in small quantities to be able to resell them to some end users at a much higher price. They knew that there are a good number of users (let’s call these users “seekers”) who will pay higher to get the best products.

However, what was not clear was how the production (supply) of these products would fare — will it be ramped up to meet the surge in demand or will it actually be even further suppressed because of factory closures. An increase in the demand-supply gap drove up the prices, fueling more arbitrage, but eventually a combination of willingness to pay and improving supply, will bring this curve back to a stable state.

👩‍💻 Democratization of arbitrage

The sellers selling those Logitech webcams on eBay were not electronics sellers and sometimes, not even regular sellers; they were just arbitrageurs who spotted an opportunity to make some money.

eBay was designed as a true P2P network, encouraging a user to be both a buyer and a seller. Users have reputations as a whole — buyer + seller; the ratings for a given user profile are the ratings for that user as a buyer and a seller. So, as a buyer, it’s very easy to start selling. Similarly, it’s also very easy to start buying from new sellers because of their reputations as good buyers. This makes the barriers for arbitraging very low and drives the shape of the curve described above. eBay democratized arbitrage by putting the ability of arbitraging in hands of regular people. It is reaping the benefits, with its stock trading at an all time high right now (though I am not sure how long it will sustain).

💪 Brand & product strength

This period of market inefficiency is a great time for some companies to validate their product and brand strength. It’s a period of price discovery. Today, cheaper Logitech models are selling for more on eBay than more expensive models of competing products. The gap between the solid-orange and the dotted-blue lines in the graph above is larger for Logitech than it is for some other brands. This means 2 things: 1) Logitech is likely underpricing some of its webcam models 2) There is demand for Logitech to introduce higher end, higher priced models.

Pricing is a complicated topic, and most products have some seekers (users whose willingness to pay is higher than the retail price). However, products are priced to maximize the overall sales. In an efficient market, it’s hard to know how big the cohort of seekers for a certain brand/product is. Covid-19 has provided a rare window into this for some product categories. This will have implications on how companies think of their market positioning and their pricing strategy. For companies that come out of Covid-19 feeling more confident about their position in the market, there is an opportunity to raise prices and improve profitability.

Covid-19 has been a shock more real than many. It’s an experiment in market dynamics and opportunities that no-one signed up for and, like experiments do, offers some very valuable insights for the future.

P.S. Opinions in this article are my own and don’t reflect the opinions of any of the companies mentioned

🐦 Twitter @setparth