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Rev Austrian Econ (2010) 23:79­96 DOI 10.1007/s11138-009-0087-3

Arbitrage and knowledge

Tyler Watts

Published online: 14 May 2009 # Springer Science + Business Media, LLC 2009

Abstract I investigate in depth the contemporary, nation-wide arbitrage phenomenon of copper penny hoarding. While penny hoarding represents a "pure arbitrage" opportunity, it also clearly demonstrates the knowledge problems that face those entrepreneurs who are fully informed about intra-market price differences. This paper contrasts the Neoclassical and Austrian views on the role of information and knowledge in arbitrage, emphasizing the greater depth in understanding to be gained from the knowledge-based Austrian approach, as opposed to the information-based Neoclassical approach. Keywords Knowledge . Information . Arbitrage . Hoarding . Entrepreneurship JEL D83 . B53

Wesley: Now, there may be problems once we're inside. Inigo: I'll say. How do I find the count? Once I do, how do I find you again? Once I find you again, how do I escape? Fezzig: Don't pester him, he's had a hard day. -from the motion picture The Princess Bride; exchange among the three heroes of the story as they prepare to infiltrate the villain's castle.

1 The how of the market process Both Neoclassical and Austrian economic theory predict that arbitrage opportunities won't long prevail on the market. If a particular commodity trades at different prices

T. Watts (*) Department of Economics, George Mason University, MSN 3G4, Fairfax, VA 22030, USA e-mail: [email protected]

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in different markets, profit-seeking entrepreneurs will buy in the under-valued market and sell into the over-valued market until any price discrepancy reflects transactions costs alone (Mises 1998 [1949]; 326,358,385). In pure markets with perfect information, we can expect the "law of one price" to prevail for all commodities (Persson 2008). Yet Austrians tend to diverge from the modern Neoclassical analysis by asking the pertinent question: just how do entrepreneurs go about exploiting these arbitrage opportunities? For Austrians, the how matters just as much as the what. Indeed, the ways in which entrepreneurs go about their pursuits in the market of competitive commerce--the how of the market process--is the flesh which gives life and movement to the skeleton of economic theory. All entrepreneurial, profit-seeking actions can be viewed as attempts to exploit arbitrage opportunities. All entrepreneurs are ultimately motivated by a perceived discrepancy between the prices of the necessary inputs and the anticipated sale price of the final product (Kirzner 1973; 46, 85-86). Arbitrage does not occur automatically when someone sees a price discrepancy-the discrepancy must be acted upon. Even in a case of what we might call "pure" arbitrage, where a commodity is purchased in one specific marketplace and re-sold in another without being physically modified, the entrepreneur's ability to exploit such an opportunity depends wholly on his knowledge of the inner workings of both markets--his business know-how. When the entrepreneur sees a price difference representing an arbitrage opportunity, he asks himself, "How could I go about profiting from this situation?" The task of this paper is to peer into this question of how. To illustrate the role and importance of knowledge in arbitrage, I shall examine indepth a "pure" arbitrage phenomenon: copper penny hoarding. This activity should be of special interest to economists, for not only does it involve what I label a "pure" form of arbitrage, but is itself a present-day instance of Gresham's Law in action, and is laden with economic relevance with respect to monetary policy. This paper focuses on the knowledge problem in economics, drawing a distinction between knowledge and information and the relevance of each for the arbitrage process. While the terms knowledge and information are often used interchangeably, it is essential for economists to make a distinction between them to gain a deeper understanding of arbitrage and entrepreneurship. For present purposes, information1 refers to mere facts, or data, regarding attributes of objects in the world: Jeff is six feet tall; Brazilians speak Portuguese; no. 1 hard red wheat is selling for $5.21 per bushel today at the grain elevator in Haswell, Colorado. Knowledge,2 however, implies understanding--the ability to apprehend and interpret facts in light of more complex theories, and to put such facts to use in human pursuits: Jeff knows how to tie knots; math majors know algebra; economists understand supply and demand graphs. An indepth investigation into the copper penny market illuminates the importance of this distinction between information and knowledge. Copper penny arbitrage demonstrates how entrepreneurs use knowledge, in addition to information, to pursue profit opportunities, and how they acquire and share the relevant knowledge they need.

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Information: knowledge communicated or received concerning a particular fact or circumstance; Knowledge: acquaintance with facts, truths, or principles, as from study or investigation; general erudition. Definitions from Dictionary.com Unabridged (v 1.1). Retrieved January 28, 2009, from Dictionary.com website: http://dictionary.reference.com/browse/knowledge

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2 The copper penny market Bad money, says Gresham's Law, drives good money out of the country. It would be more correct to say that the money which the government's decree has under-valued disappears from the market and the money which the decree has over-valued remains (Mises [1949] 1998; 447). 2.1 American debasements The history of money is strewn with cases of governments debasing their currencies.3 Debasements are usually accompanied by hoarding, and there have been recurrences of both in the United States. In a fiat currency system, hoarding of small change often indicates a depreciation of the currency unit. Either way, hoarding means the metal value of small coins, in terms of the debased or inflated currency unit, has come to exceed its face value. Additionally, hoarding typically begins with the smallest currency units, as they tend to have the lowest face value to metal content ratio. Thus hoarding of small change can be seen as indicative of inflationary effects of underlying monetary policy. The US dollar was initially defined, under the Coinage Act of 1792, on the bimetallic standard of 371.25 grains fine silver or 24.75 grains fine gold (Yeoman 2007; 200,221). The US government debased its dollar in terms of gold in 1933-34, again in 1945, and finally severed the last, tenuous link to gold in 1971 (Rothbard 1991; 5­8, 11, 30). US subsidiary coinage (dimes, quarters, and half dollars) was debased from silver to copper­nickel base metal in two phases, starting in 1965 and finalized in 1971.4 After 1971, then, US currency had become completely divorced from precious metals. All US coins were now copper-based, with admixtures of nickel in the dime, quarter, half-dollar, and dollar coins, to imitate a silvery outward appearance. Only the one-cent (penny) and 5-cent coins, which trace their lineage back to the civil war era, were unchanged.5 The venerable penny continued to be made from 95% copper, as it had been since 1864. But the "copper standard," it turned out, was also doomed. Rising copper prices through the 1970s, doubtlessly spurred on by the unprecedent3

For an excellent historical account of several important Western European currency debasements, accompanied by a rigorous model of currency provision under a metallic standard, see Sargent et al. 2002. The Big Problem of Small Change. Princeton University Press. 4 As the market price of silver rose above melt parity of $1.29 per troy ounce in the mid 1960s, the mint came into a situation of negative seigniorage with dimes, quarters, and half dollars, all of which were composed of 90% silver. In 1965, dimes and quarters were debased to nickel-clad copper, and the silver content of half dollars was reduced to 40% (see Rickenbacker, op. cit.). In 1971, the composition was again changed to match that of dimes and quarters. As the 1970 half dollar issue was small and restricted to collectors, 1969 was the last year the United States issued coins intended for circulation with precious metal content. 5 The small copper cent was introduced in 1864, as a cheap substitute for the heavier, copper­nickel cents that had been largely hoarded out of circulation due to their bullion premium which arose from civil war greenback inflation. (see Rothbard, Murray N. 2002. A History of Money and Banking in the United States Before the Twentieth Century. Auburn, AL: Mises Institute, pp. 126-127) Similarly, the nickel 5-cent coin, which contains 25% nickel and 75% copper, was introduced to replace the silver half-dime. The composition of both coins was intended to counteract potential hoarding due to bullion premia resulting from greenback inflation.

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ed monetary inflation which the gold and silver debasements facilitated, created a problem for the US Mint. The increasing price of copper made the manufacturing cost of each penny more than one cent, so that the government faced the prospect of negative seigniorage on each penny it made. The solution to this problem, much like with silver coins in 1965, was debasement. Late in 1982, the copper penny was replaced with a coppercoated zinc coin. Identical in appearance, though not in weight, to the previous issues, the new coin contained a mere 2.5% copper, the remainder being zinc. 2.2 The arithmetic of penny arbitrage The transition to much-cheaper zinc solved the looming problem of negative seigniorage, and the copper coating on the new zinc coins left the outward appearance unchanged, which maintained continuity in the coinage and avoided an obvious visual cue for hoarding of the older coins. The price of copper also receded by the mid 1980s, so that hoarding of the older-issue copper coins for their bullion value did not materialize. It takes 154 of the 1982 and earlier copper pennies to make 1 pound of copper, so the market price of copper must be above $1.54 per pound for the hoarding-out6 of copper pennies to begin to be economical. At a copper price of $1.54 per pound, the "melt value" of a copper penny is $0.01, or parity. Whenever this melt value exceeds $0.01, there is a potential profit to be made in hoarding copper pennies out of the circulating coinage. This scenario represents a "pure arbitrage" opportunity: a commodity is purchased in one market--in this case, banks-- and re-sold in another market at a profit.7 While the spot price of copper did not exceed $1.54/lb in the 1980s or 1990s (it reached peaks of $1.01 in 1980, $1.34 in 1989, and $1.38 in 1995)8, it was indeed high enough to drive the mint to largely abandon its use in pennies. Keep in mind that the mint's production cost is somewhat more than the spot copper price, due to costs of storage, processing, labor, etc. The spot price can be significantly below melt parity and yet effect a negative seigniorage for the mint. Likewise for penny-hoarding arbitrageurs, the melt value must be somewhat above the melt parity spot price of $1.54/lb for them to realize significant profits. Hoarders also face costs of processing: accessing large stocks of circulating coins, sorting the 1982 and earlier coppers from the newer zinc pennies, storage, selling fees, and the like.

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Hoarders anticipate either: (1) selling the coins directly to metal smelters or scrap dealers for their scrap price, (a significant discount from spot price); (2) holding the coins over a period of time, anticipating either further increases in the spot price, or the establishment of a premium above face value at which the coins will continue to trade, acting as a quasi-money, without ever actually being melted; (3) selling to other hoarders who anticipate 1 or 2. 7 The primary market for liquidation of copper pennies was scrap dealers; with the imposition of a coinmelting and export ban by the US Treasury in December 2006, the vast majority of copper penny sales has shifted to eBay and the like; buyers are speculatively anticipating either: (1) continued increases in the copper price, and/or (2) a repeal of the melt ban. There are no legal prohibitions on hoarding or selling copper pennies. Historical experience (i.e., the 1967­1969 melting ban) suggests that the Treasury will repeal the ban once they feel a sufficient supply of new, debased coinage has been produced to take the place of the hoarded-out coins (dates for previous melting ban from Velde, Francois. Chicago Fed Letter 235a, Feb. 2007). 8 http://minerals.usgs.gov/minerals/pubs/commodity/copper/240798.pdf Average yearly prices.

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Around the middle of 2005, the spot price of copper broke through the critical price of $1.54/lb, remaining well above the copper cent melt parity price for several years (Fig. 1). Thus, for those who are aware of the various compositions of US pennies and track the spot price of copper, a clear-cut arbitrage opportunity in hoarding copper pennies presented itself in the form of a bullion premium. Indeed, individual hoarding efforts, from tiny to tremendous in scale, began in earnest since sometime in mid-2005, when spot copper broke through $1.54/lb and continued on an upward trend. Copper prices reached a peak of over $4.00/lb in April of 2008, and remained above $3.00/lb until October 2008; thus, the melt value of each copper penny exceeded face value for over 3 years, and for more than two of those years, melt value stood at more than double face value.

3 Hoarding and the knowledge problem 3.1 The magnitude of copper penny arbitrage During this period of bullion premium, the arbitrage opportunity in copper pennies was substantial. The US Mints produced over 158 billion copper cents from 1959 through 1982.9 My analysis of data provided by dozens of penny hoarders across the US suggests that currently, copper cents average about 25% of the total stock of pennies in circulation.10 The spot price of copper reached a peak of over $4.00 per pound in July, 2008. If all the copper pennies in circulation could have been liquidated at this maximum melt value, a gross arbitrage profit potential (gross melt value minus gross face value) of $1.66 billion would result.11 Of course, liquidation of copper pennies at the spot price is unrealistic, as the spot price refers to large plates of copper ready for industrial use. Copper pennies would require smelting and re-casting to be ready for industry, and hence must trade at a discount to spot price. We can arrive at a more realistic appraisement of the size of the arbitrage opportunity by looking at the actual prices at which copper pennies traded during the time of positive bullion premium. A conservative, lower-bound price, based on eBay auctions, is 1.5 cents per copper penny (which are typically sold in lots of 5,000-- see Appendices A and B). Based on this real-world market premium, the gross arbitrage profit potential still stood, for a time, at more than $517 million.12

Data from Yeoman 2007. Although the small copper cent has been in circulation since 1864, 1959 is the most appropriate year to begin a reckoning of the number of copper cents currently in circulation. The present design (Lincoln Memorial cent) was adopted in 1959, which led to a gradual hoarding-out of the previous design (wheat cent) by coin collectors; this collectible or nostalgic value is quite apart from the copper melt value of these older wheat cents. This hoarding process has essentially run its course, with pre-1959 "wheat" cents now representing well less than .5% of the circulating penny stock. 10 Data compiled by author from individual reports posted at http://realcent.forumco.com -see Appendix C. 11 Gross melt value=$4.00/lb÷154 pennies/lb×0.25(418 billion[pennies minted since 1959])=$2.71 billion gross face value=0.25(418 billion)/100=$1.05 billion 12 gross market value=$.015×.25(418 billion)=$1.57 billion gross face value=.25(418 billion)/100=$1.05 billion

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Fig. 1 Copper Spot Market Prices.

3.2 Coin hoarding: method, machinery, and scale Many individuals who noticed the penny arbitrage opportunity attempted to pursue it in several different ways, with wide variation in ambitions, specific goals, and profitability. At the low-intensity end of the penny hoarding spectrum are the casual hoarders; these are usually coin-collectors who use labor-intensive hand-sorting methods to separate copper from zinc cents. They are interested in accumulating small hoards of copper cents, either for immediate resale in the penny-bullion market or for long-term speculation, as well as building penny collections and thrilling to the discovery of rare or odd coins.13 Pennies are packaged by the armored services in standardized boxes containing 50 rolls, or 2,500 coins ($25 face value). By my rough classification, casual hoarders would typically sort anywhere from two to ten boxes per week. Profit rates are negligible; my estimates, based on my own experiences with hand-sorting, place an upper bound gross profit estimate of $6.25 per hour for the most efficient level of hand-sorting.14 Subtracting for transportation costs leaves the casual hoarder with meager profits, if any. Above the casual sorters in both intensity and volume are transitional hoarders. They aim to either: (a) make a modest profit by sorting and selling coppers, or (b) accumulate a significant hoard, into the range of hundreds or thousands of pounds,

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Penny hoarders routinely come across pre-1959 wheat cents, some of which are quite rare and command large numismatic premia; additionally, hoarders rarely, but routinely, find pre-1910 Indian head cents, which can also be of high numismatic value, and mint errors, foreign coins, etc. 14 This estimate is based on personal experience. A good hand sorter can go through two boxes (5,000 coins) per hour with the use of a small scale. At a 25% copper rate, this yields 1,250 copper pennies per hour. At $0.015 per copper, the gross profit comes to (1,250×$0.015)­(1,250/100[face value])=$6.25/h.

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of coppers, speculating that the bullion premium will grow or at least hold steady. In the worst-case-scenario of a copper price collapse, such hoarders take comfort in the assurance that their hoards can never fall below face value. Based on the volume of coins they sort, typically ten to 50 boxes per week, transitional hoarders frequently make use of capital equipment to speed the sorting process. A favorite sorting tool is the Ryedale "Apprentice," a professionally made sorting machine designed specifically for and marketed to US penny and Canadian nickel15 sorters. According to advertising on Ryedale Coin's website,16 the Apprentice model boasts a flow rate of 18,000 coins per hour; this rate would allow a mid-level sorter to sort through ten boxes in 2 hours (allowance being made for extra time to open the boxes and unpack the rolled pennies). Assuming an average copper rate of 25%, and a conservative bullion premium of 1.5¢ per copper, a transitional sorter thus equipped could knock out a gross profit of over $30 in 2 hours (subtracting acquisition, zinc-dumping, and transactions costs associated with selling, packaging, and shipping to arrive at net profit figures). At the high end of transitional sorting--50 boxes per week and use of a Ryedale Apprentice, penny arbitrageurs could be looking at gross margins of over $150 a week; still meager, but sufficient for many to justify their hoarding hobby or contemplate making the leap to the next level--"professional" hoarding. Professional hoarders are bona-fide arbitrageurs, aiming at speculatively accumulating large stocks of coins, and/or immediately profiting on the bullion premium. Professional hoarders typically sort through hundreds of boxes of pennies per week, employing a range of sophisticated machinery to aid in the operations, including Ryedale sorting equipment, coin counters, coin rollers, and even devices to break open coin rolls.17 Professional hoarders who are focused on long-term copper accumulation measure their hoards by the ton; those who focus on immediate profit sell upwards of tens of thousands of copper pennies per week. Finally, and perhaps most importantly, professional sorters are keen to find and cultivate personal contacts at all stages of the coin sorting game. They are well connected with the banks, the metals markets, and the coin hoarding community in general. 3.3 Neoclassical vs. Austrian analysis Even though professional, and to a lesser extent transitional, hoarders search through and sort fantastic quantities of pennies, their numbers are scanty and they failed to make a significant dent in the circulating copper penny stock after more than 2 years of a large bullion premium. At the peak of penny arbitrage, prices of copper pennies were far from uniform, even accounting for transactions costs.18 Thus, the Neoclassical theory's prediction that price discrepancies cannot long endure is not

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At the peak of the boom in nickel prices, the profit potential for sorting out 1955-1981 Canadian nickels, which were made of pure nickel, was quite large and far more significant than that for US pennies. see www.coinflation.com/canada/ 16 www.ryedalecoin.com 17 Though they make use of such tools, professional-level hoarders prefer to obviate the tedious job of "roll-cracking" by dealing strictly with 5,000 count bags of loose pennies. 18 Due to the melting ban enacted in 2006, the primary market for copper pennies is now eBay. The eBay market has become fairly well standardized in quantity, with the typical lot size being 5,000 coins, and shipping charges, which hover at or slightly above the Postal Service's flat-rate box rate of $8.95.

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neatly fulfilled in the copper penny market. Of course, those adhering to the Neoclassical view would likely assert that people who know about the bullion premium, yet do not engage in hoarding, have simply appraised the prospective revenues vs. the prospective costs of hoarding, and concluded that the prospective profits of hoarding do not cover the opportunity costs. In short, in the Neoclassical world it is simply people's appraisal of transactions costs which prevents them from attempting to exploit the arbitrage opportunity. In fact, in equilibrium, the height of transaction costs comes to determine whether a price discrepancy constitutes a profitable arbitrage opportunity or not (Kaldor 1939; 3). But this Neoclassical analysis in which all information pertaining to the arbitrage opportunity at hand is given, and the question of do or do-not is merely a matter of transactions costs, falls short on some level. Surely there are people who know about the bullion premium on copper pennies, and would like to exploit it if they only knew how. We may take these folks' knowledge of the relative price difference for granted; what they lack is the knowledge of how, specifically, to go about profiting from it. In this case, it is not the appraisal of transactions costs of hoarding versus the potential profits on the bullion premium, but ignorance of how to be a successful hoarder, that stymies any prospective arbitrage attempts. Thus, the very idea of arbitrage presumes a distinction between at least two levels or types of knowledge on the part of the profit-seeking entrepreneur. One of the first economists to seriously plumb the depths of this information/ knowledge distinction was Israel Kirzner. Kirzner aptly labels the former "information­ knowledge," which is simply knowledge of the facts of price differences for a particular commodity in different markets; he terms the latter "action­knowledge," which is the know-how that enables one to take the necessary actions to pursue the opportunities latent in information­knowledge (Kirzner 2005; 77). As Kirzner states, Two individuals may "know" the same facts; one of them grasps the opportunity which these facts represent, the second fails to do so. ... The one who failed to grasp the opportunity expressed in these known facts had "information­knowledge" of them, but not "action knowledge." (2005; 79-80) Prior to Kirzner, F.A. Hayek had also pointed to the relevance of this distinction: ...price expectations and even the knowledge of current prices are only a very small section of the problem of knowledge as I see it. The wider aspect of the problem of knowledge with which I am concerned is the knowledge of the basic fact of how the different commodities can be obtained and used, and under what conditions they are actually obtained and used,... (1948; 51, emphasis added) Peter Boettke addresses this same distinction, phrasing it in terms of information vs. knowledge. He points out that the Austrian economists, in highlighting the distinction, were correcting a critical oversight by the Neoclassical theorists: I want to suggest that the terms information and knowledge have also been translated into economic language in a manner that distorts their standard meaning. In order to incorporate information and knowledge into the standard economic model, the concepts were conflated and treated as a commodity that was deliberately bought and sold in the market. ...

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...Knowledge is ever changing and is multifaceted, while information is something fixed. In other words, information is the stock of the existing known, while knowledge is the flow of new and ever expanding areas of the known. (2002; 266) This distinction between information­knowledge and action­knowledge, is essential, in the Hayek­Kirzner view, to gaining a deeper understanding of how markets work, and how people work within markets to achieve profits. Neoclassical arbitrage and search theory tenaciously present the arbitrage process as a series of optimization problems; with price and preference data in hand, "People are whipped into line by the confluence of their utility functions and a market mechanism" (Wagner, unpublished). Standard Neoclassical theory fails to recognize the vital distinction between information and knowledge. In the neoclassical tradition, George Stigler was the first to investigate the economics of information in his well-known essay (1961). Stigler posits that information is a valuable resource, and that market agents will engage in a search for information up to the point at which the marginal benefits from search are equated with the marginal costs, the result being "optimal search". Stigler's essay is limited to search over market prices, and he admits that ignorance of prices is only one aspect of the information problem (1961, 213). Yet Stigler immediately confuses the issue by labeling the phenomenon of price dispersion, by itself, as "the measure of ignorance in the market" (1961, 214). Thus, even though Stigler suggests, however subtly, the multi-faceted nature of the information problem, he limits his analysis to mere price information. In Stigler's view, then, the economics of information is strictly about optimal search, and optimal search is primarily over prices. Moreover, Stigler uses the terms information and knowledge interchangeably, glossing over the crucial distinction which the Austrian literature raises. Stiglerian search, then, is strictly over information, not knowledge. Stigler, moreover, begs the question of knowledge, in the Hayek­Kirzner sense, throughout his essay. This is evidenced when he states, "Each dealer faces a distribution of (for example) buyers' bids and can vary his selling prices with a corresponding effect upon purchases" (1961, 216). This statement falters under scrutiny of the Austrian view of knowledge. Dealers don't, strictly speaking, "face" bids, but seek them. If dealers were to actually just face a distribution of bids by the mere fact of being a dealer, there wouldn't be much to the "art of selling." Austrian analysis takes a gigantic step deeper into problems of information, knowledge, and search by asking how the agent ever comes to find himself in an optimization problem in the first place. Given that everyone ultimately starts off from a state of total ignorance, how do entrepreneurs and arbitrageurs know to do what it is they do? What interests the Austrians is not the solution to the optimization problem, but the process of discovering opportunities, learning how to best pursue them, and engaging in the work--the labor, bargaining, planning, and so forth--that transforms opportunities into realizations. In short, the Austrian approach emphasizes the primacy of entrepreneurship, and the means by which entrepreneurs overcome problems of knowledge. The entrepreneur discovers, learns, and employs; he does not, properly speaking, optimize. He does not see transactions costs as data in an optimization problem, but as obstacles in his quest for profit; he strives to overcome such obstacles by his alertness to new, cheaper, faster, better ways of pursuing arbitrage opportunities (Kirzner 1973).

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The Austrian point of departure in analyzing the phenomenon of arbitrage, then, is to ask how entrepreneurs come to learn both information and knowledge required to engage in arbitrage. Those who learn how to exploit the opportunity profit from it. Those who learn best tend to earn most. Learning per se is a matter of psychology, but an important component of it is one's participation in knowledge-networks which specialize in disseminating specialized knowledge. The learning process and consequent flow of knowledge is, of course, lumpy, imperfect, and time-consuming. It is not automatic, and economists seeking to shed light on the market process should not take it as given or assume it to function in the background. Assessing this aspect of the knowledge problem helps us to understand why price discrepancies may persist for long periods. Such discrepancies might, in a standard view, be indicative of market inefficiency or failure. A more nuanced, knowledge-based view, on the other hand, might show how the market process of arbitrage and entrepreneurship works to overcome, sooner or later, the ever-present obstacles thrown up by ignorance. Arbitrage depends on knowledge. 3.4 Discovery and learning in the penny hoarding community Much like Inigo Montoya19, the potential penny hoarder may initially ask questions along these lines: How do I go about getting hold of large quantities of pennies? Once I get the pennies, how do I economically sort the coppers from the zincs? Once I sort them, how do I go about selling the coppers? How do I turn the zincs back into ready cash for buying more pennies? These problems are difficult enough for experienced hoarders, let alone novices possessing only price information and a desire to profit from it. In answering them, the coin hoarder acquires the know-how necessary to exploit this particular arbitrage opportunity. Where might a would-be penny arbitrageur go to gain some hoarding know-how? There are two main avenues a novice could take. First is simply learning-by-doing: the entrepreneur­hoarder goes out into the world, starting with a particular idea about how to proceed, and comes to refine his know-how through a process of trial and error. This category--we'll label it primary knowledge--reflects the entrepreneur's experiential learning process (Kirzner 1973, 36; Hayek 1948, 46). The other means of learning consists of querying others who already posses some know-how and being taught by them; let's call this secondary knowledge. Pioneering hoarders gain primary knowledge in several ways: encounters with bank tellers, tinkering in their workshops, making phone calls to bankers, armored services, smelters, etc. Some of these pioneers, in turn, share their experiential primary knowledge with potential hoarders, who possess information­knowledge about the bullion premium, but lack, to varying degrees, the action­knowledge to exploit it.20 An online community of sorters and hoarders has cropped up at a handful of websites and web forums, notably the forums of http://realcent.forumco.com. Begun in May of 2006,

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v. opening quotation above, p. 1. Many hoarders or prospective hoarders are informed of the copper penny-bullion premium via www. coinflation.com. A website oriented towards those with sensibilities about inflation and hard money, coinflation tracks the bullion values (the "melt values") of US gold, silver, and currently circulating basemetal coinage. Whereas the realcent forums are a repository of hoarding knowledge, coinflation.com is a continuously updated repository of price information.

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the realcent site contains an active and growing discussion of the ins and outs of contemporary coin hoarding. The closely-interconnected web communities of penny hoarders, gold-bugs, treasure-hunters, and the like, tends to ensure that web-savvy people with proclivities or sensibilities that might lead them to penny hoarding are drawn towards these types of forums. The realcent forums have become the principal repository of coin hoarding knowledge, where experienced, pioneer hoarders with primary knowledge gladly share their know-how with would-be or greenhorn hoarders. This teaching and learning aspect of the forum has enabled many hoarders to set off on their arbitrage venture, ab initio, with a wealth of know-how, largely based on secondary knowledge. The knowledge and information sharing that goes on at the forums covers all aspects of hoarding. In addition to being a storehouse of knowledge, the forum also serves as an incubator for continual flashes of knowledge discovery, as bits of new information, and new ideas about hoarding, are brought to the fore, churned over, and assessed by members of the forum in search of a meaningful new synthesis by which to guide their actions. In penny hoarding, both primary and secondary knowledge are relevant; the forum allows its users to share and synthesize their primary knowledge, and thus gain new secondary knowledge, in a way that the two types mutually reinforce each other, and the forum itself becomes an epicenter of both knowledge and learning--a knowledge institution that aids each entrepreneur's individual quest for profits while providing novices with access to the best knowledge in the market. 3.5 Examples of knowledge-sharing from the realcent forum Penny hoarders face the following basic problems in the pursuit of this arbitrage enterprise: 1. 2. 3. 4. Acquiring pennies Sorting for copper Returning zincs Selling coppers

Discussions on the realcent forum address all of these knowledge problems. A few examples from the forum postings illustrate the depth and breadth of knowledge sharing that takes place there. 3.6 Getting pennies to sort Post entitled, "What do you tell the banks?..."(2-13-08): What do you guys say to the bank? How do you order 10 boxes at a time? Which banks are most willing? My bank is a Chase, but I opened a National City bank account today to broaden my resources. Response 1: I took the advice of many of the members on this forum; I continue to open new bank accounts with minimum balances as often as possible. Then I order anywhere from 4­6 boxes from each bank on a regular basis without raising any eyebrows.

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Response 4: One other hint, instead of asking for 10 boxes say that you would like to order 10 boxes for next Thursday. Banks usually don't have 10 extra boxes of pennies in the vault and asking for 10 boxes clues them in that you are new to the game.... ...Also you can ask for a standing order. I have two banks at the moment that have been ordering me pennies every week now for months. Just watch for the bank's breaking point and try not to exceed the "norm" by too much at any one bank. 10 boxes a week is no problem for a lot of banks, but I never go over that... Response 5: Also consider taking in some chocolates for the tellers that help you. I particularly favor the chocolate coins that come in the little net bags. Really sweetens the deal. I limit my orders at any one bank to 24 at a time.. but I have a really bad habit.. LOL.

3.7 Returning zincs Post "Getting Rid of Zincs," 11-30-07: There is much discussion of "sorting" here, and not as much information about returning the zincs. This seems to be a sticking point for many potential sorters. Perhaps a good open discussion would be welcome about the many methods of returning or re-injecting zincolns. ... ...If your in a small market area, IE not enough banks etc, you may have to float the zinc a bit longer, and return it in a larger market, say once a month or something. Best thing to do is call every bank in the yellow pages, and boldly ask what types of coin services they have, tell them you have large amounts of "change" and need a reliable place to drop it. Find the ones that have free coin counting to members. I have one that is free, and one that charges 2% for quantities over $5 dollars. If I have a heavy week of hoarding say 450 in zinc to return, I'll take $300 to one, and $150 to the 2% place. It takes a bit of time to get these relationships built, but if you do the work you will probably be rewarded, and like I said if you do get a good thing going, then you should treat it like gold, because it's one of the 4 key components of hoarding copper. which are as follows. 1. 2. 3. 4. aquiring coins sorting the coins returning the zincs (wrapped or loose) Selling or hoarding the copper Everyone please feel free to jump in here and add your personal experiences, ... This post was followed with 98 replies, in which forum members shared experiences and advice on the best means of returning zincs. This brief sampling of knowledge sharing through the realcent forum demonstrates the depth and breadth of the know-how necessary for successful penny hoarding. It also attests to the distinction between information and knowledge, and

Arbitrage and knowledge

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the fact that much of the knowledge pertinent to penny hoarding cannot be subsumed under Neoclassical search theory. Consider the hoarder's problem of returning zinc pennies to the bank (Problem 3). A relatively unknowledgeable hoarder is unaware of the advantages of returning his zinc coins to a bank with a coin counter. Only once he becomes aware of the existence and benefits of this means of "dumping zincs" can he commence with search, which he then performs by canvassing banks he knows of, querying them as to whether they offer a coin counter and what are the conditions attached to using it. The important question for the economist in this matter is how does the tentative coin sorter learn, or discover, a good method of dumping zincs? We could say that he searches for a way, but this is only colloquial; he's not engaging in anything like optimal search because he does not know the height of the costs nor the benefits of the yet-to-be-discovered means of action. In other words, the search for know-how is not Stiglerian optimal search, for the costs and benefits are unknown, and hence the arbitrageur has no way of optimizing his search function. Only once he has gained the knowledge of the new method and its applicability, can he engage in optimal search in order to apply it; only then will he have an idea of the benefits of the new method and a way to proceed in reckoning the costs thereof. Clearly, knowledge precedes search, for one must know what one is looking for. Once one knows what one is looking for, the task of optimal search, in the Stiglerian sense of canvassing the relevant sellers for price information, becomes somewhat automatic and relatively uninteresting. The question, "whence the knowledge?" is of overall more importance to the arbitrage process. Furthermore, the penny hoarding phenomenon suggests that the knowledge sharing through spontaneously arising knowledge-institutions can be as important, if not more so, than individual learning by trial-and-error, for the acquisition and dissemination of the action­knowledge that is essential for arbitrage. The forum's role in this knowledge-discovery process is clearly revealed in a post by "Madeuce," a professional-level Canadian nickel sorter: Post entitled, "My name is MaDeuce and I sort nickels," 9-2-07: It all got started when I read about the temporary regulation that the US Mint issued banning the melting and export of pennies and nickels. When I saw the article in the Wall St. Journal, I said, "Damn, I wish I'd known about that six months ago!" But it got me to thinking and reading on the net. I ran across THIS forum. Based on what I read here, I eventually connected the dots and determined that a similar condition potentially existed with nickels in Canada. Without a doubt, I owe the people that created this form, and those that participated in it prior to my reading it, a huge debt; if I hadn't run across this forum, I really doubt that I would have been able to put all the pieces together. Y'all were definitely way ahead of the curve! (emphasis in original) Action­knowledge, in addition to information, is shared and discovered via the forum discussions, demonstrating the Hayekian conjecture that markets and their attendant knowledge-institutions, are important not only for the discovery of knowledge, but its dissemination to the appropriate set of actors. Economists have attempted to induce entrepreneurial knowledge discovery in experimental settings. Demmert and Klein (2003) failed to observe entrepreneurial discovery in what

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amounted to an engineering challenge they posed to experimental subjects. Crocket et al. (2006), on the other hand, observed the emergence of entrepreneurial discovery, in both production and trade, in a simulated economy. Their paper is especially relevant to the question at hand, which the authors state as follows: [H]ow might agents discover comparative advantage in an institutionally unstructured and informationally decentralized economy, and spontaneously learn to order their production and exchange decisions through emergent institutional or personal relationships that they create? (2006; 1) What Crocket, Smith, and Wilson observe in the economics laboratory is paralleled in the real-world arena of coin hoarding; entrepreneurs discover the relevant knowledge they need to make the most of perceived opportunities, and institutions emerge that facilitate the spread of this knowledge. The clear picture of this discovery process, observed in the laboratory and confirmed by the penny hoarding phenomenon, indicates the importance of knowledge, and the primacy of knowledge discovery, for all manner of arbitrage pursuits--ultimately, all productive activity.

4 Implications of the knowledge problem Knowledge matters just as much as information for arbitrage. Success in penny hoarding, and arbitrage in general, does not depend on one facing the lowest amongst possible ranges of transactions costs, but on one's aptitude for acquiring know-how, and his access to sources of knowledge. Institutions of knowledge, such as web forums, are an important means of sharing information, but of greater significance is their role in communicating the localized, specialized, idiosyncratic knowledge needed to pursue even simple-looking, "pure" arbitrage opportunities. Many economists in the Austrian tradition have stressed the importance of the institutional setting of entrepreneurship. Coyne and Leeson, for instance, identify three main sets of formal institutions--economic, political, and legal--necessary for productive entrepreneurship. They also note, but do not discuss, the role of informal institutions. The experience of the penny arbitrageurs suggests that knowledge institutions are important in the dispersal of the know-how that is essential for entrepreneurs to effectively pursue the arbitrage opportunities they see around them. A more complete picture of the institutional setting of entrepreneurship would then include knowledge institutions as shown in Table 1 (in Coyne and Leeson's table, under economic institutions). Further refinements could then be made between formal (e.g. trade schools) and informal (e.g. internet forums) knowledge institutions. Commercial know-how is essential to entrepreneurship, in addition to the freedom to trade and contract (property rights) and access to markets (open markets/low barriers to entry). We might tend to take the discovery and learning of this commercial knowledge for granted because, as Kirzner noted, people "tend to notice that which it is in their interest to notice." (1985; 28) Yet, if we leave knowledge institutions out of the picture, we might miss out on an important determinant of comparative entrepreneurial success between people or even between cultures. For instance, the bulk of commercial knowledge in a

Arbitrage and knowledge Table 1 A Social Order Conducive to Productive Entrepreneurship Economic institutions Private property Well-defined Enforceable Freedom to contract Capital markets Open trade Low barriers to entry and exit (Coyne and Leeson 2004, 238) Political institutions Checks and balances Federalism Fiscal Monetary Accountability Transparency Legal institutions Rule of law Generality Stability Predictability Independent judiciary

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Functional and accessible courts

particular industry may be attained by way of informal institutions like the realcent forum, but government policy insists on formal training at approved schools to stimulate output and employment in said industry. A potential institutional impediment to entrepreneurial discovery may result, lying outside of the more foundational institutional categories of property, contract, market access, etc. The resulting empirical question of whether formal or informal knowledge institutions are more important or relevant for the discovery and spreading of commercial knowhow, both within society and within particular sectors of commerce and industry, depends wholly upon the identification of the information/knowledge distinction.

5 Conclusion F. A. Hayek stressed that markets serve to coordinate knowledge; dispersed, localized, and tacit knowledge are all put to economic use by the incentives of the price mechanism; the ensuing division of knowledge which the market economy allows yields great economies of knowledge and economic progress (Hayek 1948, 77­91). Hayek's central lesson--prices coordinate--is essential to understanding markets, yet we should take note that prices would not do much good if people did not know how to act on them. As a corollary to the coordination of individual incentives and economies of knowledge that the price mechanism brings about, the spontaneously arising knowledge-institutions, which specialize in the compiling and dissemination of action­knowledge, facilitate the actual working-out of entrepreneurial arbitrage activities. The genius of the spontaneous market order lies in this dual economy/diffusion of knowledge: prices, which convey a wealth of information in shorthand form and thus give rise to tremendous economies of knowledge, guide entrepreneurs in the direction of their action. Complementary to this price mechanism, knowledge-institutions help to supply entrepreneurs with the knowhow they need to undertake arbitrage ventures. Because these knowledge institutions are themselves decentralized and spontaneously arising, they tend to provide relevant, correct, and useful knowledge, compared to centralized, bureaucratic organs of "education" which may tend to provide reams of information (which may or may not prove to be trivial), but little in the way of appropriate action­knowledge.

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The institutions of the market, in an elegant yin­yang balance of economizing on knowledge where appropriate and providing rich, detailed knowledge where appropriate, tend to provide the right amount of both information and knowledge for arbitrage, entrepreneurship, gains from trade, and a progressing economy.

Appendix A

Table 2 Copper Penny Prices Realized on eBay.com--All Auctions eBay copper penny 5,000 lot sales 2-week period from 5-12-08 to 5-26-08 Date Price Shipping Total Net revenue Statistics (minus shipping) Statistics (total price)

5/12/2008 5/12/2008 5/12/2008 5/12/2008 5/13/2008 5/14/2008 5/15/2008 5/17/2008 5/17/2008 5/18/2008 5/19/2008 5/19/2008 5/19/2008 5/19/2008 5/20/2008 5/22/2008 5/23/2008 5/24/2008 5/25/2008 5/26/2008 5/26/2008 5/26/2008 5/26/2008 5/26/2008 5/26/2008 5/26/2008 Mean Mean

$81.00 $73.00 $74.99 $73.00 $72.01 $69.35 $112.50 $77.00 $76.00 $84.99 $66.59 $68.59 $68.59 $83.02 $76.97 $67.88 $87.91 $71.00 $72.00 $76.00 $77.00 $76.00 $71.00 $112.58 $70.99 $70.01 $77.31

$10.00 $12.00 $11.00 $10.00 $9.95 $11.00 $10.95 $9.99 $11.99 $11.95 $11.95 $11.95 $10.00 $10.00 $10.00 $9.80 $9.99 $9.99 $12.00 $12.00 $12.00 $9.95 $11.00 $12.00 $10.83

$91.00 $85.00 $85.99 $83.00 $81.96 $80.35 $87.95 $85.99 $96.98 $78.54 $80.54 $80.54 $93.02 $86.97 $77.88 $97.71 $80.99 $81.99 $88.00 $89.00 $88.00 $80.95 $81.99 $82.01 $88.13

$31.00 $23.00 $24.99 $23.00 $22.01 $19.35 $62.50 $27.00 $26.00 $34.99 $16.59 $18.59 $18.59 $33.02 $26.97 $17.88 $37.91 $21.00 $22.00 $26.00 $27.00 $26.00 $21.00 $62.58 $20.99 $20.01 $27.31 $77.31 $88.13

$10.00 $122.50

$10.00 $122.58

Arbitrage and knowledge Table 2 (continued) eBay copper penny 5,000 lot sales 2-week period from 5-12-08 to 5-26-08 Variance Std. Deviation Median Mode Average price per penny

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$135.85 $129.76 $11.66 $11.39 $74.00 $85.50 $76.00 $85.99 $0.0155

Appendix B

Table 3 Sample of Copper Penny Prices Realized by the Author on eBay.com Sale Date 11/22/ 2007 1/17/2008 3/7/2008 3/15/2008 3/22/2008 4/20/2008 5/2/2008 Item 2,500 copper cents 2,500 copper cents 5,000 copper cents 5,000 copper cents 5,000 copper cents 5,000 copper cents Winning Cents per Gross price eBay Paypal Total Net bid penny (net) (incl. shipping) fees fees fees revenue $36.00 $35.75 $92.00 $95.00 $78.05 $75.44 1.44 1.43 2.06 1.84 1.90 1.56 1.50 $44.95 $44.70 $112.00 $100.95 $103.95 $87.00 $90.00 $2.75 $1.60 $4.35 $2.61 $1.60 $4.21 $6.65 $6.54

5,000 copper cents $103.05

$6.17 $3.55 $9.72 $43.33 $4.93 $3.23 $8.16 $33.84 $5.89 $3.31 $9.20 $35.80 $5.29 $2.82 $8.11 $19.94 na $2.91 $25.44

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Appendix C Average rate of copper pennies in circulation

Average Copper Percentages

35 30

Copper Percentage

25 20 15 10 5

0

7 7 06 07 7 7 07 7 8 08 -0 -0 -0 -0 -0 8 -0 551-0 16 30 14 18 -3 10 998-1 13 11 56492312 1408 to 3910 -0 8

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References

Boettke, P. J. (2002). Information and knowledge: Austrian Economics in search of its uniqueness. Review of Austrian Economics, 15(4), 263­274. Coyne, C., & Leeson, P. (2004). The plight of underdeveloped countries. Cato Journal, 24(3), 235­249. Crockett, S., Smith, V. L., Wilson, B. J. (2006). "Exchange and Specialization as a Discovery Process." Available at SSRN: http://ssrn.com/abstract=930078. Demmert, H., & Klein, D. B. (2003). Experiment on entrepreneurial discovery: an attempt to demonstrate the conjecture of Hayek and Kirzner. Journal of Economic Behavior and Organization, 50, 295­310. Hayek, F. A. (1960 [1948]). Individualism and economic order. Chicago: University of Chicago Press. Kaldor, N. (1939). Speculation and economic stability. Review of Economic Studies, 7(1), 1­27. Kirzner, I. (2005). Information­knowledge and action­knowledge. Econ Journal Watch, 2(1), 75­81. Kirzner, I. (1973). Competition and Entrepreneurship. University of Chicago Press. Kirzner, I. (1985). Discovery and the Capitalist Process. University of Chicago Press. von Mises, L. (1998). Human action. Auburn, AL: Mises. Persson, K. (2008). "Law of One Price". EH.Net Encyclopedia, edited by Robert Whaples. February 10, 2008. Available at eh.net: http://eh.net/encyclopedia/article/persson.LOOP. Rothbard, M. N. (1991). The case for a 100 percent gold dollar. Auburn, AL: Mises. Sargent, T., & Velde, F. (2002). The big problem of small change. Princeton University Press. Stigler, G. J. (1961). The Economics of information. Journal of Political Economy, 69(3), 213­225. Yeoman, R. S. (2007). A guide book of United States coins (17th ed.). Atlanta: Whitman.

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