The Speculator’s Edge, Eight

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