Speculation

Instructor: Tyler Cowen, George Mason University

Speculation is often considered to be morally dubious. But, can speculation actually be useful to the market process? This video shows that speculation can actually

Speculation is often considered to be morally dubious. But, can speculation actually be useful to the market process? This video shows that speculation can actually smooth prices over time and increase welfare.

Speculators take resources from where they have low value and move them through time to where they have high value. We also take a look at speculation in the futures market — for instance, can orange juice future prices help predict Florida weather? Let’s find out.

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Today, we're going to be looking at speculation. Speculation and speculators are often considered to be morally dubious. Speculation is associated with gambling, and gambling is morally dubious. When a speculator gets rich people wonder, "What has this person really done for the social good? What have they really produced of true value?" What we're going to show is that using a basic model of speculation, speculation can be quite a useful part of the market process. So let's take a look.

 

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.

 

Again what's the basic point here? What's the basic idea? It's that what speculators do is they take resources from where they have lower value and they move them through time to where they have higher value. That's a very useful thing to have happened. That increases welfare, that makes the speculators money, but because of the invisible hand, in the right circumstances the incentives lead the speculators to do the right thing, thereby increasing value for society as a whole.

 

Here is one more important point. In order to speculate in a market like the market for oil, you don't actually have to have a storage tank where you're going to store your oil. You can do it another way -- that's through the futures market. Futures are contracts to buy or sell specified quantities of a commodity or a financial instrument at a specified time in the future, at a price that is agreed upon today. So how would this work? Suppose that Tyler thinks the price of oil will be greater than $50 per barrel in 12 months from now. But Alex thinks the price of oil will be lower than $50 in 12 months. Tyler agrees to buy from Alex 1,000 barrels of oil 12 months from now at a price of say, $50 per barrel. It's a futures contract. Let's see what happens after 12 months pass. Suppose that 12 months from now, the price of oil on the market is $82. That we call the spot price. That means Tyler was right, the price of oil went up, and by a lot.

 

So what do they do then? Tyler has two options. He can accept the oil from Alex, pay $50,000 to Alex, and then turn around and sell the oil for $82,000, netting Tyler $32,000. But Alex doesn't have any oil. Tyler also doesn't really want to take the delivery of the oil and then turn around and have to sell all that oil. That can be a big pain. Instead, Tyler and Alex come to an agreement, perhaps through a clearing house. Alex gives $32,000 to Tyler and they close the contract out in cash. Notice that either way, Tyler nets $32,000 and Alex is out $32,000. The second method is usually more convenient. Neither Tyler nor Alex actually have to deal in the oil. They only have to deal in the cash value of the futures contract. In fact, futures contracts are usually settled in cash, rather than through physical delivery.

 

What this means is that through the futures market, anybody can speculate in oil. Now we're not suggesting you actually do this -- it's one way to lose a lot of money very quickly. But the point is, you don't have to accept or deliver oil to speculate in the oil market. That's a good thing because there are many people who may know lots of things about conditions in the Middle East or about the oil market who don’t themselves have the facilities to store or deliver oil. The better speculators can predict the future, the more money they can make. When they make their predictions, they change the prices in futures markets. Prices in futures markets often have information built into them which tells you something about the future.

 

Think, for example, about the Florida orange juice crop. What determines whether the crop is really going to be a bumper crop, in which case, the price of orange juice will be low, or whether the crop is going to be a small crop, in which case the price will be high. Very often it's the weather that matters. This led one economist, Richard Roll, to look at the weather forecasts of the National Weather Service and to see whether orange juice future prices could help to predict Florida weather. What he found, in fact, is that they can. There was additional information in the orange juice futures prices that allowed for improvements in the weather forecasts from the National Weather Service. Lots of information is embedded in market prices.

 

Let's end where we began with the image problem speculators have. One of the issues is that speculators raise prices today, but lower prices in the future. Everyone sees the price increase today, but fewer people see that the future price will be lower than it would have been without the speculation. Why is society better off with speculation? Remember, the speculators are moving resources through time from lower to higher valued uses. Of course, the speculators don't always guess correctly. When they guess incorrectly, they'll be moving resources from higher valued uses to lower valued uses. We don't want that, but the speculators have got their own money on the line. They have a huge incentive to be right, and when they're wrong, they have to take big losses. Over time, bad speculators, speculators who aren't good at forecasting the market, they tend to go bankrupt. And the good or better speculators will become a larger share of the market.

 

Let's also remember that we really want somebody to be able to predict the future. We really want people to be thinking about the future. We really want to give people an incentive to think about future events, both good and bad, and how those events will impact production and consumption decisions. Speculation markets, futures markets, they give people strong incentives to think carefully about the future. Indeed, these markets have been shown to be much better predictors of the future, much better ways of seeing into the future than our alternative institutions which rely less on incentives and rely less on markets. We'll talk about all of that more in the next lecture. Thanks.

 

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No one and everyone controls the market. Market will have taken into account your speculation as well while determining the equilibrium price.

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