Markets Link Over Time – Speculation

… a core concept in Economic Analysis and Atlas102

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Concept description

Tyler Cowen (reference below, video on right), describes the way markets link over time through the actions of speculators and mechanisms such as futures markets.

Cowen notes that while speculation is often considered to be morally dubious, speculation actually be useful to the market process because 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.

How speculators improve social welfare

The increase in welfare is illustrated by the fact that today’s loss in value due to speculators taking supply out of the market (red area) is smaller than the future gain in value when speculators bring the supply back on the market (green area). It also tends to smoothen prices.

SpeculationSmoothesPrices

Speculators do not actually have to physically take supply off the market (through, for example, buying and storing the commodity) and then physically put it back on the market (taking it out of storage and selling it). They can use Futures – contracts to buy or sell specified quantities of a commodity or financial instrument in the future at a price agreed upon today.

Cowen reflects on why society benefits from speculators but why speculators are underappreciated by society:

SpeculationSummary

Practice questions

From http://www.mruniversity.com/node/192287, accessed 1 May 2016.

  1. Sometimes speculators get it wrong. In the months before the Persian Gulf War, speculators drove up the price of oil: The average price in October 1990 was $36 per barrel, more than double its price in 1988. Oil speculators, like many people around the world, expected the Gulf War to last for months, disrupting the oil supply throughout the Gulf region. Thus, speculators either bought oil on the open market (almost always at the high speculative price) or they already owned oil and kept it in storage. Either way, their plan was the same: to sell it in the future, when prices might even be higher. As it turned out, the war was swift: After one month of massive aerial bombardment of Iraqi troops and a 100-hour ground war, then President George H. W. Bush declared a cessation of hostilities. Despite the fact that Saddam Hussein set fire to many of Kuwait’s oil fields, the price of oil plummeted to about $20 per barrel, a price at which it remained for years. How much money did speculators lose or make on each barrel?

Atlas topic, subject, and course

The Price System and Price Regulation (core topic) in Economic Analysis and Atlas102 Economic Analysis.

Source

Tyler Cowen, Speculation (11-minute video), Principles of Economics – Microeconomics, Marginal Revolution University, at http://www.mruniversity.com/courses/principles-economics-microeconomics/speculation-oil-futures-market, accessed 1 May 2016.

Page created by: Ian Clark, last modified 1 May 2016.

Image: Tyler Cowen, minute 1:14 of Speculation (11-minute video), Principles of Economics – Microeconomics, Marginal Revolution University, at http://www.mruniversity.com/courses/principles-economics-microeconomics/speculation-oil-futures-market, accessed 1 May 2016.