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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- [Tyler] 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.

- [Narrator] If you want
to test yourself,

click “Practice Questions.”

Or, if you're ready to move on,
just click “Next Video.”

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