Arbitrage is “the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices.” Once the arbitrage spread closes, the profit is made and the opportunity no longer exists. According to Austrian Economics, entrepreneurs’ profits “derive from the services he performs in detecting and eliminating arbitrage opportunities, thereby allowing supply and demand for a given good to meet.” By recognizing and acting on opportunities, the entrepreneur moves markets toward equilibrium. So entrepreneurial arbitrage is a low-risk way of exploiting gaps between what the market demands and what it’s being supplied until the spread closes.
There is very little “invention” involved—startups imitate or slightly modify someone else’s idea and only introduce breakthrough products or new business models many years later. This is what Peter Drucker calls creative imitation. The technology and market demand already exist, but the creative entrepreneur understands what the innovation represents better than the original innovators. This also includes packaging current technologies into new business models. Paul Graham calls this an idea that’s “a square in the periodic table”—if it didn’t exist now, it would be created shortly.
Duration of the arbitrage spread depends on the size of the imbalance and the nature of competitive advantages. The imbalance size is the difference between what the market demands (total size of the “job” and the level of performance demanded) and what is currently offered. Competitive advantages can affect the duration because very low barriers to entry can cause a gap/imbalance to be filled much more quickly by the many entrants who seek any remaining excess profit.
Startups usually start in niche markets but can expand based on a number of factors. For example, durable moats don’t exist at first but can be developed over time while the arbitrage gap is closed. According to Mohnish Pabrai, “these events have no pattern and cannot be forecast when a startup is being formed. They happen to a very small minority of startups.” Only certain kinds of innovations lend themselves to strong competitive advantages, and hence large operations. (I.e. Standard Oil, US Steel and Nabisco succeeded while National Wallpaper, Standard Rope & Twine, and US Button failed.)
- Ford—combined assembly line & interchangeable parts with gas-powered auto production. Most consumers already had the need for a car but couldn’t afford high-end models. Size of the need was huge, achieved strong economies of scale at first but after ~15 years competitors caught up and the gap closed.
- Starbucks—there was a gap between low-end convenience coffee and high-end coffee shops. Combined chain restaurant with coffee shop experience, market was very large & performance demand wasn’t too high at first. Entrants couldn’t match the reach and brand trust of Starbucks (which emerges from the habitual nature and consistently good experience across locations.)
- Facebook—there was demand for a way to connect to others on the internet that was being poorly met. Copied the “social network” concept but implemented it much better, gaining a foothold in the niche school market first then expanding based on advantages in network effects. Size of imbalance was huge and entry barriers prevented entrants from closing gap ahead of them.