The Economic Impacts of Speculation

But who buys the corn, and spy? Here is where the speculator and the speculative market enter: The speculator agrees to buy the warehouse owner’s corn now for future delivery. This transfers the risks from the original owner to the speculator. You might wonder exactly why the speculator agreed to take on the corn-price risk. Perhaps the speculator believed that corn prices would rise and that he would make a super normal return on the investment; perhaps he sold a “futures contract” (one which promises future delivery) to buyers who wished to lock in the price of corn before it rose; perhaps he sold it to investors wed wished to put a small corn position in their portfolios.

The point is that someone, somewhere, had an economic incentive to take on the risk of corn- ,price fluctuations. speculative markets serve to improve ‘the price and allocation patterns across space and time as well as to help transfer risks. These tasks are performed b .speculators who, spurred on by the desire to profit from price changes, in fact show the invisible hand at work, If we look behind the veil of money, we see that ideal speculation reallocates goods from times of feast (when prices are 10\\’) to limes of famine (when prices are high).

Our discussion has suggested that ideal speculative markets can increase economic efficiency. Let’s see how. that identical consumers have utility schedules in which satisfaction in one year is independent of that in every other year, Now suppose that in the first of 2 years there is a big crop-say, 3 units per person-while the second year has a small crop of only 1 unit per person. If this crop deficiency could be foreseen perfectly, how should the consumption of the 2-year, 4-unit total be spread over the 2 years? Neglecting storage, interest, and insurance costs, total utility and economic for 1 M 2 will hi only when consumption is here.

Why is uniform consumption better than any other division of the available total? Because of the law of diminishing marginal utility. This is how we might reason: “Suppose I consume more in the first year than in the second. My marginal utility (MU) in the first year will be low, while it will be high in the second year. So if I carry some crop over from the first to the second year, I will be moving from MU times to high-MU times. When consumption levels are equalized, MUs will be equal and I will be maximizing my total utility.” A graph can illuminate this argument. If we measure utility in dollars, with each dollar always denoting the same marginal utility, the demand curves for the risky commodity would look just like the marginal utility schedule of Figure ~1 on page 87. The two curves of Figure 11-2(a) on page 208 show what would happen with no carryover and with unequal consumption: Here, price is determined first at AI’ where higher SISI intersects DD, and second at A2′ where the lower supply S:!S:! intersects DD. Total utility of the gray shaded areas would add up to only (4 + 3 + 2) + 4, or $13.

But with optimal carryover of 1 unit to the second year, as shown in Figure 11-2(b), Ps and Qs will be equalized at EI and £Z, and the total utility of the shaded areas will add up to (4 + 3) + (4 + 3),or$14 per person. A little analysis can show that the gain in utility of $1 is measured by Figure 11-2(b)’s dark . blue block, which represents the excess of the second unit’s marginal utility over that of the third. This shows why the equality of marginal utilities, which is achieved by ideal speculation, is optimal. Our discussion has focused on one kind of speculation and arbitrage-that involving commodities.

Even more important today are activities involving financial assets.such as stocks, bonds, mortgages, and foreign exchange. Every day, literally trillions of dollars of assets change hands as people speculate, hedge, and invest their funds. The general principles underlying financial speculadon, hedging. and arbitrage are exactly the same as those outlined here, although the stakes are even higher. 207 Ideal speculation serves the important function of reducing the variation in consumption. In a world with individuals who display diminishing’ marginal utility, speculation can increase &o~ utility and all~
ational efficiency’.

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