Entrepreneurship as arbitrage

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The surest way for an entrepreneur to make profits is through arbitrage. If an entrepreneur notices that a seller is willing to sell a good for less than a buyer is willing to pay for it, the entrepreneur can buy it from the seller, and sell it to the buyer, reaping a profit and making both the buyer and seller better off as a result. Such arbitrage profits are easy to notice, tend to be small, and tend to be rapidly competed away. Nevertheless, especially in financial markets, arbitrageurs are able to make steady, and occasionally spectacular, profits. Most entrepreneurial activities involve production and time, however, and these two elements mean that when an entrepreneur acts on an entrepreneurial insight, the entrepreneur's profit is not a sure thing.

Consider, for example, a person who notices that a particular type and quality of apples are selling for $0.25 each in city A, and are selling for $0.50 in city B. Further assume that apples can be transported from city A to city B for $0.10 each. An entrepreneur can buy apples for $0.25 in city A and sell them for $0.50 in city B, making a profit of $0.15 per apple, after transportation costs. However, the entrepreneur must consider that some apples may be damaged or spoiled in shipping, which could lower or completely eliminate the profit. Furthermore, prices may change so that by the time the entrepreneur actually gets the apples to city B, they may be selling for $0.35 or less. Unless the transaction is instantaneous and the transaction costs are zero (or certain), what appears to be a profit opportunity may not be one in fact.

Production might be analyzed as just a more complicated type of arbitrage. An entrepreneur notes that enough capital to produce 100 units of some output can be rented for $50, and enough labor to produce 100 units of that output can be hired for $100, while the output can be sold for $2 per unit, which would result in a profit of $50. If the entrepreneur acts on this observation, a number of factors could cause that apparent profit to disappear. The prices of the inputs or output may change, or it may turn out that it takes more capital and/or labor to complete the job than at first it appeared. If the production process is well-established, keeping costs in line may be a matter of good management, but if the entrepreneur is acting on an opportunity to produce something that never has been produced before, there may be considerable uncertainty with regard to the production methods and costs. In the real world, one will rarely observe a profit opportunity that is a sure thing.

Entrepreneurship can be viewed as an extension of arbitrage, in that the entrepreneurial insight always involves noticing that some particular things can be bought in particular locations for some particular prices, perhaps then be combined in a production process to generate something that can be sold in a particular location, perhaps at some later time, for an amount greater than the cost of the inputs. Yet with production and time intervening between the purchase and sale, entrepreneurship also involves taking a risk that the profit will vanish. Still, the depiction of entrepreneurship as arbitrage helps identify the essential entrepreneurial insight: a particular combination of goods and services could be purchased, and perhaps combined in a production process, and could then be sold for more than the purchase price. The entrepreneurial insight could be as simple as noticing price discrepancies in the market - pure arbitrage opportunities - or could be as complex as envisioning a new production process, or a new type of good or service that could be offered on the market. In all cases, it is the observation that goods and/or services can be bought at some price, perhaps combined in a particular way, and then sold for more than the purchase price.

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