The gains from improved market efficiency: trade before and after the transatlantic telegraph

Abstract

This article looks at the gains from improved market efficiency in long-distance grain trade in the second half of the nineteenth century, when violations of the law of one price were reduced due to improved information transmission. Two markets, a major export centre, Chicago, and a major importer, Liverpool, are analysed. We show that the law of one price equilibrium was an 'attractor equilibrium'. The implication is that prices converged to that equilibrium in a tâtonnement process. Because of asymmetrically timed information between markets separated by long distances there were periods of excess demand as well as excess supply, which triggered off the tâtonnement process. Over time, adjustments to equilibrium, as measured by the half-life of a shock, became faster and violations of the law of one price become smaller. There were significant gains from improved market efficiency, which took place after the information 'regime' shifted from pre-telegraphic communication to a regime with swift transmission of information in an era that saw the development of a sophisticated commercial press and telegraphic communication. This article is the first attempt to actually measure the gains from improved market efficiency and it demonstrates that improved market efficiency probably stimulated trade more than falling transatlantic transport costs. Deadweight losses decline significantly as markets became more efficient. The conventional view that Harberger triangles are almost always insignificant is challenged.

Information Frictions and the Law of One Price

“…Some newspapers report weekly wheat prices for some American varieties over longer time series, but the prices do not have any variation, which means there was no underlying trade based on the commodity, and prices were just copied forward at the same level for months. Ejrnaes and Persson (2010), who also fail to find grain price data that cover the years around 1866, explain that these years were a period when the export of US grain ceased temporarily.…”

“…However, these are available at most at weekly frequency, and qualities of wheat are often not comparable as there exist so many local varieties. Furthermore wheat exports from the United States to Great Britain ceased for several years around 1866 (Ejrnaes and Persson 2010). 25 Several market reports pointed out that New York used the same classification scheme as Liverpool, as this was the most important destination for cotton.…”

“…Surprisingly, these rich data have never been systematically digitized. I use market reports from newspapers on both sides of the Atlantic -The New York Times and the Liverpool Mercuryto construct a new, daily data set that includes cotton prices in New York and Liverpool, export flows 1 Previous papers using exogenous variation in information frictions used the presence of mobile phone coverage (Jensen 2007;Aker 2010), internet kiosks (Goyal 2010) or even the transatlantic telegraph connection (Ejrnaes and Persson 2010), but none of these papers observed information flows directly. Observing information ("news") and relating them to prices is much more common in the finance literature (for example Cutler et al 1989, Koudijs 2013 and freight cost between the two ports, stock levels in both markets and detailed information flows for the period of one year before and one year after the telegraph connection.…”

“…Aggregate demand from cotton millers follows a stochastic, autocorrelated process. Shipping takes time, so merchants have to make their export decision before they know the realization of the demand shock, 4 and will base it on the prices they expect to 2 A related paper by Ejrnaes and Persson (2010) estimates faster shock transmission after the telegraph using weekly wheat prices. However, their price series exhibits a gap of 15 years around the time of the establishment of the telegraph connection, which makes it difficult to distinguish the effect of the telegraph from other confounding trends such as the introduction of futures trading in the 1870s.…”

“…3 To my knowledge, my paper is the first to provide evidence that the telegraph had real effects on exports. An earlier paper by Ejrnaes and Persson (2010) does not observe trade flows, takes real effects as given and estimates the welfare gains from the transatlantic telegraph using estimated demand and supply elasticities from other studies that are based over yearly rather than weekly time horizons. 4 Aggregate demand shocks cannot be fully insured away, as borrowing cotton from future harvests is impossible.…”