Instructor: Tyler Cowen, George Mason University

Speculation : The attempt to profit from future price changes, usually by buying assets that are expected to increase in price. This is from the video “ Speculation

Speculation: The attempt to profit from future price changes, usually by buying assets that are expected to increase in price. This is from the video “Speculation” in the Principles of Microeconomics course.



Speculation is actually very similar to an example we've already talked about. Remember our example, when oil prices are low on the west coast, and high on the east coast, this gives entrepreneurs an incentive to buy low and sell high to move oil from the west, where it has low value, and bring it to the east, where it has higher value. Speculators do the same thing, but instead of moving resources through space geographically, they are moving them through time.

For example, suppose you believe that oil prices will be higher in a year due to, for example, a very destructive war. You might think there will be such a war in the Middle East, and that's going to push up oil prices in the next year. You can make a profit by buying oil now when the price is low, storing that oil, and then selling it next year when the price is high. Buy low, sell high. That's speculation - the attempt to profit from future price changes.

Is this a bad thing? What we're going to show is that speculation tends to smooth prices over time and to increase welfare. Why does it increase welfare? Exactly for the same reasons that moving oil from the west coast to the east coast increases welfare. You're taking oil from where it has low value and moving it through time to where it has higher value. You're increasing value and increasing welfare.

Let's take a look at that with our model. Here's two markets: today's market and the future market for oil. Let's look at what happens without speculation. Here's our demand, here's our supply. I've just drawn a vertical supply curve for simplicity. So, production today is high, that means today's price is low. If there's a destructive war in the Middle East, then production in the future will be lower and price in the future will be higher. That's what happens without speculation.

Now let's consider what happens with speculation. Remember, we begin with a situation where the price today is low and speculators expect that the price tomorrow because of this war will be high. What do speculators want to do? They want to buy low and sell high. They want to buy today and sell in the future. If speculators buy today, they're going to take some of the current production, take that production, and put it into storage. They'll take it off the market and store it. The supply curve to the market is this supply curve. This then gives us consumption, which is equal to production minus what the suppliers put into storage. Notice that with speculation, the price today goes up because the speculators have taken some of that supply off the market.

What happens in the future? In the future when the price is high, the speculator’s going to want to take what they have out of storage and sell it in the market. The supply curve in the future becomes equal to production plus what is being pulled out of the inventory. Production is low in the future because of disruption due to, let's say, again, this destructive war, but consumption will be higher than production in the future because suppliers are taking some of the inventory out, and selling it into the market. Notice that in the future, the speculators are pushing the price down.

What about welfare? This is slightly tricky, but if we just follow our rules, let's look at consumer surplus, which is what is going to matter here with the vertical supply curve. It's simpler that way. Well, consumer surplus, what's going to happen? There's a loss in value today when speculators take oil off the market. That oil is not consumed, those units are not consumed, and because they're not consumed there is a resulting loss in value.

However, notice what the speculators are doing. In the next period, there's a gain in value. The consumption would have been here but because of the speculation, because the good comes out of inventory, consumption is now higher. The value of that consumption is equal to this green area. Since the green area is bigger than the red area, speculation increases welfare. It also stabilizes the price over time. The price today goes up, but the price in the future goes down. We get a more stable price.

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