The Speculator’s Edge,
Eight
Why Speculators get
Paid
Speculators only get paid if they do their job. The answer
to how and why speculators get paid is found in basic textbook economics.
In Economics,
Samuelson and Nordhaus identify three dimensions in which speculators “link up
markets”: over time, over space, and
over risks.
Markets separated by
distance may have different prevailing prices for identical goods. If the
difference between prices exceeds the costs associated with transportation, speculators
will buy the goods in the market offering the lower price and sell in the
market bidding the higher price, realizing the difference in the two prices. Since
the goods must be transported to the place of sale, costs of shipping must be
subtracted from the trading profit. The activity of the speculators is called arbitrage. As the arbitrage continues,
prices will tend to fall in the market having the higher price (because of
speculative buying). By arbitraging the
two markets, speculators cause goods to move from the lower priced market to
the higher priced market, until the prices of the two markets come into line.
The movement of goods from the lower priced market to the higher priced market
is economically optimum, since the
higher price reflects higher demand or lower supply. The important point is
that speculative profit resulted only from performing an economic service. If
the speculators were not conferring a benefit on the system, they would not be
rewarded for their activity.
The second category
of speculative activity occurs across time…Assume that the consumer’s
utility schedule for cotton is constant over two years. (In other words, the
demand for cotton is the same in both periods.) In the first year, there is an
unusually large crop of cotton, say five pounds per person, and in the second
year, a small crop of only three pounds per person. In year one, since the crop
is big, the price will fall to low levels. Low
price levels will encourage consumption of the cotton by marginal consumers, consumers who would not otherwise use the
cotton in year one except for its low price. In year two, the small crop comes
in and prices soar. Now only those consumers who desire the cotton badly enough
to pay the high price will consume it. What
has happened is that marginal consumers in year one displaced higher order
consumers in year two. As a result, total utility over the two-year period
was not maximized.
We can go a step further and show that if the circumstances
of the bumper crop in year one and the shortage in year two could have been forseen, then the total utility
for the two years would be maximized only if the consumption was equal in both
years. This results from the fact that the consumer’s utility schedule is the
same in both years.
Note that there are several key words in the preceding
paragraph: :if the circumstances…could have been for seen.” Speculators make a living out of forseeing
things. In the example, astute speculators who recognized the unusually
large nature of the crop in year one might very well decide to take some cotton
into inventory, figuring that higher prices would prevail the following year
either because the low prices of year one would discourage cotton growers from
planting so much or simply because the odds favour some bad weather sooner or
later. The speculative activity in year
one would tend to support the price of cotton, preventing marginal consumption.
Then, in year two, there would be enough cotton to go around, as speculators
made up the shortfall in supply be selling cotton from their inventories… Once
again, you can see that speculators providing a service get paid for doing so.
The third important
category of speculative services is the absorbtion of risk…Imagine that you
own a copper mine that produces 100,000 pounds of copper per year. Your
production costs amount to $.60 per pound. You are operating your mine with the
expectation that the price of copper will be $.75 per pound. But, alas, we live
in a risky world. Prices might go as low as $.50 per pound or as high as $1.00.
At the low end, you will lose $10,000 per year. At the high end, you will make
$40,000. If you are like most rational business persons, you would much prefer
a sure sale of your production at $.75 cents per pound, which will yield your
anticipated profit of $25,000…Why?
There are two reasons. First, since copper mining is your principle means of income, to the extent
possible, you prefer to run it on as certain a basis as possible. What
happens if you get unlucky for a couple of years? You are wiped out of your
means of making a living. If you wish to
assume a high degree of risk, you will do it with capital that you have
specifically earmarked for that purpose.
The second reason is that the marginal utility of the
windfall profits you might earn if copper goes to $1.00 per pound is less than
the marginal disutility if copper declines to $.50 per pound. In other words, the added income means
less, perhaps since it only enables you to buy better clothes, than the loss of
income, since it might preclude you from buying clothes altogether.
So, we conclude you are risk-averse. You would jump at the
opportunity to sell your next year’s production of copper to some speculator
right now for $.75 even though prices might be higher later. You might even
sell it for $.72 or a little less – after all, you can’t expect some speculator
to do you such a big favour unless you pay him a little something for taking
the risk. We call what you pay him a risk premium.
Again, you can see that speculators
get paid for performing a valuable economic service, in this case, assuming
from producers unwanted risks of fluctuating prices. And we can go one step
further and say that the greater the risk assumed by a speculator, the greater
the potential rewards that he or she can reap.
Economists say that speculators get paid for reducing
variations in consumption and for assuming unwanted risks of ownership. I say
that speculators get paid for demanding supply and supplying demand.
Used in context, we mean the same thing. My terminology is employed for a
simple reason: It reminds me in a practical way of what I must do as a
speculator to win. In all the previous examples, in each case, successful
speculators as a class were purchasing from producers, taking goods into
inventory, and supplying them to consumers as a class. The words, “demanding
supply and supplying demand” help remind me to do this.
No matter how you say
it, this is the key to the whole business of speculation. Your job is to
increase the utility of the economy by seeing that the people who want things
most get them. If you do your job as a speculator, you will be amply
rewarded. If you don’t, you won’t
You might also note that speculators who misread economic
circumstances are guilty of performing a disservice. By selling when they
should be buying and vice versa, they increase dislocations and risk.
Fortunately, the markets have a way of dealing with these people: by summarily
taking their capital away and giving it to the speculators who are doing their
job.
The Speculator’s
Edge,
Albert Peter Pacelli
