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Chapter 16: Problem 4

Prices for many goods are higher in the city of Shenzhen on the mainland of China than in the city of Hong Kong. An article in the Economist noted that "individuals can arbitrage these differences through what effectively amounts to smuggling." a. Explain what the article means when it notes that individuals can "arbitrage these price differences." b. Ultimately, what would you expect the result to be of individuals engaging in this arbitrage? Is your answer affected by the fact that the government of China requires a visa for Shenzhen residents to visit Hong Kong and regulates the number of trips that can be made between the two cities in a given year? Briefly explain.

Short Answer

Expert verified
Arbitrage in this context means purchasing goods in Hong Kong where they’re cheaper and selling them in Shenzhen at a higher price, thus profiting from the price difference. This action over time tends to balance out prices in disparate markets. While regulations such as visa requirements and limitations on travel may slow down the speed of this price harmonization, they don’t eliminate the opportunity for arbitrage completely unless the costs overshadow potential profits.

Step by step solution

01

Understanding Price Arbitrage

Arbitrage in economic context means the simultaneous buying and selling of the same goods or securities in different markets to take advantage of price differences. When the article mentions that individuals can 'arbitrage these price differences', it means that people can buy goods in Hong Kong where prices are lower and sell them in Shenzhen where prices are higher, thus making a profit from the price disparity.
02

Possible Outcomes of Arbitrage

In Economics, arbitrage plays a crucial role in ensuring that prices do not deviate substantially from fair value for long periods of time. With many individuals taking part in this arbitrage, over time the prices in Shenzhen and Hong Kong should start to converge. This is due to the increased demand for goods in Hong Kong driving up prices, and the increased supply of those same goods in Shenzhen driving down prices.
03

Effect of Government Regulations

The requirement of visa for Shenzhen's residents to visit Hong Kong, along with the regulation of the number of trips that can be made, may slow down or restrict the arbitrage activity. Due to these restrictions, the frequency and quantity of goods being transported for arbitrage could be limited, thus slowing the speed at which price convergence would occur. Yet, these restrictions do not eliminate the opportunity for arbitrage, unless the cost associated with obtaining a visa and the limitation on travel exceed the potential profit from arbitrage.

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