Speculation

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 is 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.

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 that increase welfare? Exactly for
the same reasons that moving oil from the

west coast to the east coast to increase
its 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 wanted
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 speculators going to want to
take what they have out of storage and

sell it to 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

overtime. The price today goes up but the
price in the future goes down. We go to

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 in other way, that's through the

future's 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 passed.

Suppose 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 buy 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 to 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 on 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

made a lot of things about conditions in
the middle east or about the oil market

who daunt 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 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. They 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.
Every one 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

raise of seeing into the future that 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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