The Speculator’s Edge, Nine

The Speculator’s Edge, Nine

How Speculators get Paid

So far we have learned…

1) The pricing process is a social process. Prices are the results of subjective valuations of individual members of society and are subject to change at their whim. Ludwig von Mises, an economist of the conservative Austrian school put it this way:

“But supply and demand are only the links in a chain of phenomena, one end of which has this visible manifestation in the market, while the other is anchored deep in the human mind.”

The process is not scientific. It is not mathematical. It is not mystical or astrological. On an individual level it is psychological. On a mass level it is social.

2) All known prices are historical facts. The notion of current market prices is fictional. Prices are neither current nor of the market. Trades that have occurred are historical facts. They occur only between individuals.

3) There is no such thing as fair value. Value is in the eye of the beholder. In fact, the law of marginal utility tells us that the value of a good varies even on an individual level, depending on how much of it the individual already has. When a trade occurs, it occurs because the parties to the trade disagree as to the utility of the good traded. For the trade to have occurred, it must have been subjectively viewed as advantageous to each party.

4) All prices are independent of one another. Each valuation is an individual valuation. It is subject to change at no notice and for no reason. In assessing an uncertain future, a person may use only experience and reason. Admittedly, past prices are a part of man’s experience and as such must play a part in his or her thinking about the future. But it is the anticipation of future conditions that determines current valuations, not past prices.

5) The supply and demand curves are fictional descriptions that never occur. That ceteris paribus (all things being equal) greater supply would exist at higher prices is a rational conclusion. But ceteris are never paribus (non-price determinants never are the same).

6) While ultimately price depends on current utility to consumers, at any given moment it reflects speculative assessment of future utility. Consumers determine price. But, it is not merely current consumption that determines price; it is the anticipated consumption as well.

7) The people doing the anticipating are speculators. Speculators act as conduits between producers and consumers assuming unwanted risks of production and rationing supply among consumers so as to maximize utility.

The Speculator's Edge,
Albert Peter Pacelli

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

The Speculator’s Edge, Seven

The Speculator’s Edge, Seven

The Important Role of the Speculator

In the previous instalments we learned that the subjective valuations of consumers ultimately dictate how society’s scarce productive resources will be allocated. If the markets were comprised of only producers and consumers, the process would be very inefficient. Consumers are concerned with their needs today. They purchase the food, clothing, and other goods they want today. They are rarely concerned with next year’s desires, and when they are, they are probably acting in a speculative capacity (which, of course, all of us are free to do). By looking to the future, speculators assure that society’s productive resources will be allocated not only according to the current preferences of consumers, but also taking into account their probable needs for tomorrow.

The objective of speculators is to profit from anticipated changes in conditions. Unlike those who purchase for consumption, speculators purchase in anticipation of being able to sell later at a higher price, and they sell in anticipation of buying in at a lower price. Accordingly, the valuation process of speculators differs significantly in character from that of consumers. Consumers are interested only in the current utility of a good to them. Speculators purchase not for their own consumption and not based on current utility alone. Instead, speculators are interested in what they assess the utility of a good to consumers will be in the future.

If conditions were static, the market would cause goods and services to be produced and distributed such that no further action by any individual would be perceived to be advantageous. Sellers would sell all that they were willing to sell at the prevailing price. Buyers would buy all that they were willing to buy. Prices would reach equilibrium and then become final. Trade would cease. Society’s utility would be maximized. There would be no reason to speculate, no benefit that speculation might confer on the economy.

But conditions change continually and the needs, valuations, and means of consumers change as well. And it is here that the speculator enters the picture. While it is the preference of consumers that ultimately determines the price of a good, it is the activity of speculators that pushes the market forward. The action of speculators as a class does not cause prices to reflect current utility, but instead moves prices to reflect future utility. As prices are determined in the markets there can be no distinction between the demand of consumers and that of speculators. That is, the speculators compete with consumers based on the speculators’ assessment of the consumers future needs. To succeed, speculators must have a keener ability to adjust to changing conditions than producers or consumers.

The Speculator’s Edge,

Albert Peter Pacelli

The Speculator’s Edge, Six

The Speculator’s Edge, Six

Basic Economic Concepts essential to Speculation

7) How Consumers Direct Production through the Market

The ultimate arbiter of price is the consumer. As we have seen, the consumer’s valuation is based upon his or her subjective appraisal of the utility of a good. If the consumer needs something and can make an advantageous trade, he or she does so. If the price is too high, he or she will not pay it. Good business people know that they cannot stay in business for very long by producing what they wish to sell – they must produce what their customers wish to buy.

The market directs the individuals that comprise it. It tells producers what and how much to produce, and where, how, and when to deliver it. It also determines which of the consumers who desire goods will obtain them. It does this through the mechanism of price.

If consumers want more of something than is currently being produced, producers recognize the increased demand and raise their prices. The increased prices serve two functions. The most immediate impact is to ration the existing supply by providing the goods only to those consumers willing to pay the increased price. Marginal consumers, the ones that were not willing to buy at the lower (but not the higher) price, are precluded from buying. Equally important, but usually slower to occur, the higher prices encourage (1) more production of goods for which demand has increased and (2) reduced production of marginal goods of a different nature.

Supply and demand meet each other in many different locations and under many different rules. They meet in your grocery store. They meet on exchanges and in boardrooms. They meet on street corners too.

Producers supply the goods that consumers demand.

They can do it inefficiently at the direction of a centralized government as is common in some socialist and communist countries. Or they can do it efficiently, as directed by speculators in a free economy. The next instalment of this series will go on to show how speculators direct the markets to maximize the utility of society as a whole.

The Speculator’s Edge,

Albert Peter Pacelli

The Speculator’s Edge, Five

The Speculator’s Edge, Five

Basic Economic Concepts essential to Speculation

5) The Law of Market Equilibrium

The law of market equilibrium states that markets tend to equilibrium, a state in which neither the buyers nor the sellers see any need to change the price or quantity of the goods they are trading. This occurs at the price at which goods clear – that is, where producers sell as much as they are willing and able to sell and consumers buy as much as they are willing and able to buy, and further trading ceases.

How and why the law of equilibrium works may be easily seen if we combine our supply-and-demand schedules as follows:

                    Quantity          Quantity

Price            Demanded       Supplied       Effect on Price Structure

$1.50/lb        500 lbs             6000 lbs        Sellers will compete to fill limited demand,

                                                                    lowering prices

$1.00/lb       1000 lbs            5000 lbs         Sellers will compete to fill limited demand,

                                                                    lowering prices

$.50/lb          2500 lbs           2500 lbs         Equilibrium price occurs and trade is

                                                                     maximized

$.25/lb          5000 lbs           1000 lbs         Buyers will compete for limited supply,

                                                                     raising prices

$.10/lb          6000 lbs             200 lbs         Buyers will compete for limited supply,

                                                                     raising prices

Note that the equilibrium price in the above example is $.50 per pound of cotton, and, at that price, the maximum trade of 2500 pounds will take place. Assuming static conditions, once this 2500 pounds of cotton has been exchanged, no further trade will occur.

If the price were higher than the equilibrium price, producers would compete with each other for the relatively limited demand of consumers. Producers compete by lower price. The price would fall to equilibrium. (Surplus conditions)

If the prices were under the equilibrium price, consumers would bid prices up (or producers would simply raise them to ration goods) until demand and supply came into line at equilibrium. (Shortage conditions)

At equilibrium, there is neither a shortage nor a surplus. Here, producers sell all that they are willing to sell and consumers buy all that they are willing to buy. When distribution is complete, the market is said to “clear” and further trading ceases.

You might be thinking, why doesn’t the market ever seem to go to equilibrium and clear in the real world?

Although there is some academic debate on the extent to which equilibrium is ever achieved, at least one important school says that the market in fact is always at equilibrium. Even in highly organized, actively traded markets like those found on U.S. securities and commodities exchanges, trading ceases frequently – sometimes for an instant and sometimes for significant periods. Ultimately, however, conditions change. People’s needs change. They eat, then grow hungry all over again. They are born and they die. Their valuations change. A price that a moment ago was too high for a potential buyer now looks good, so he or she buys. As life goes on, the price structure of goods must fluctuate.

6) Shifts in Demand and Supply

If for some reason, demand for cotton increased under conditions of static supply, the equilibrium price of cotton would shift (rise) from $.50 per pound to $.75 per pound.

Of course, the supply for cotton could shift as well. If the supply for cotton dramatically increased, the producers, whose cost of production has been suddenly reduced would be willing to sell more cotton at reduced prices. The increase in supply under static demand would cause the equilibrium price to fall from $.50 per pound to $.35 per pound.

The Speculator’s Edge,

Albert Peter Pacelli

The Speculator’s Edge, Four

The Speculator’s Edge, Four

Basic Economic Concepts essential to Speculation

4) The Laws of Downward-Sloping Demand and Upward-Sloping Supply

Demand is the quantity of a good that buyers are willing and able to purchase at a given price.

Supply is the quantity of a good that sellers are willing and able to sell at a given price.

The law of downward- sloping demand says that, ceteris paribus (all things being equal), demand is inversely related to price. The law of upward-sloping supply says that, ceteris paribus, supply is directly related to price. In other words, in a free market, where the non-price determinants remain the same:

  

as price increases, demand decreases

as price increases, supply increases

as price decreases, demand increases

as price decreases, supply decrease

These relationships are often depicted in demand and supply schedules and charts. A demand schedule shows the relationship between the quantity of a good demanded and the price charged. The demand schedule includes not only the amount actually demanded at the current prevailing price, but also the amount purchasers would be willing to buy at different prices.

Price……………………..Quantity Demanded

$1.50/lb………………….500 lbs

$1.00/lb………………….1000 lbs

$.50/lb………………...…2500 lbs

$.25/lb…………………...5000 lbs

$.10/lb…………………...6000 lbs

Similarly, supply schedules show the relationship between price and the amount of a good that sellers are willing to sell.

Price……………………..Quantity Supplied

$1.50/lb………………….6000 lbs

$1.00/lb………………….5000 lbs

$.50/lb………………...…2500 lbs

$.25/lb…………………...1000 lbs

$.10/lb…………………...200 lbs

The laws of upward-sloping supply and downward-sloping of demand follow our common sense. In general, if the price of a good is high, we will buy less of it than if it is lower. By lowering prices, producers can frequently entice new purchasers to buy and existing purchasers to buy more.

It is extremely important to note that while demand is inversely related to price, the relationship is not necessarily one to one. Let’s take an example. A luxury car costs, perhaps $120,000. I do not own a luxury car. If they cut the price to $60,000, I would buy one. If they cut the price to $30,000, I might not buy a second, because its marginal utility to me is less than $30,000. But if they reduce the price to $1, I might want to buy seven of them.

The law of supply operates in the same fashion. If there is plenty of something around, we are unwilling to sacrifice much to get it. As the supply becomes scarce, what we are willing to pay will increase as well, though, again, not necessarily on a one-for-one basis.

There is another way of saying all this that you should consider. Everything else being equal, if producers decide to increase the quantity of goods sold, they can do so only by decreasing the price at which they offer their goods.

The Speculator’s Edge,

Albert Peter Pacelli

The Speculator’s Edge, Three

The Speculator’s Edge, Three

Basic Economic Concepts essential to Speculation

3) Money and Price

  

Now suppose Fred takes a box of burgers over to Murray, the roof repairman. As it turns out, Murray has just returned from the doctor, who told him to cut down on cholesterol. This puts Fred in a spot because, while Murray has something Fred wants, Fred doesn’t have anything Murray wants. Or does he? It turns out that Murray is a sportsman who likes to hunt on weekends for fun. Murray sees Fred’s new club and says he would gladly re-roof Fred’s hut in exchange for one just like it. So back Fred goes to Barney’s, where he trades the box of burgers for another club. Then he returns to Murray’s and makes the deal.

Something important has happened here. Instead of purchasing the second club for his own consumption, Fred traded first with Barney for the purpose of entering into a second transaction with Murray. In other words, Fred’s demand for the second club reflected nothing more than its exchange value to him. Its consumption value was important only to Murray. This is called an indirect exchange. Virtually all exchanges made in advanced society are of this nature.

Fred, Barney, and Murray now have a problem. Obviously, clubs and brontosaurus burgers are not particularly useful media of exchange. What is needed is something easier to carry, more durable, with generally recognized beauty or utility. Nails, gems, copper, nickel, silver and gold are all candidates, and, in fact, have been used by one society or another. One by one the alternatives get whittled down, usually not by any formalized decision process, but by custom and usage. Today the most universally recognized medium of exchange (excluding for the moment bank notes of the U.S. Federal Reserve and other currencies) is gold.

We are now in a position to define money…In the narrowest sense; money is a commodity that is universally employed as a medium of exchange. I say in the narrowest sense, because as we have become more sophisticated we have often replaced commodity money with other forms of money that have no underlying commodity value. Like dollar bills or the bits and bites in a computer and/or cyberspace that represent dollar bills.

 

It is astonishing that, for all the fuss we make about money, so few of us understand its nature or from whence its value derives. Money originated as commodity money. Initially, it had no value other than its consumption or production value. However, as its usefulness in facilitating indirect exchanges grew, its value also grew to a premium over its commodity value. It acquired money value. Unlike other goods, the value of money as money depends solely on its usefulness in facilitating exchange. Take away its exchange value, and the value of commodity money reverts back to its commodity value. From 1873 until the early 1930s, the value of silver declined as most countries demonetized it in favour of gold. During World War I, as many countries replaced gold with bank notes and Treasury notes, the value of gold declined as well.

The almighty dollar is the ultimate expression of the evolution from commodity money to what we call fiat money. Not long ago it was backed by silver – that is, the paper money could be exchanged for (substituted) for a given quantity of silver, a commodity that had both commodity value and money value. Once liberated from its precious metal backing, the dollar became nothing more than paper money – that is, its commodity value disappeared. The dollar is called fiat money because it is created out of paper by fiat of the United States government. Its current value is based on custom and belief only. If anything happened to destroy that belief, its value would revert to its consumption value only – that is, it would be worth the paper it is printed on, nothing more. 

Now that we know what money is, let’s return to our friends, Fred and company, to find out a little more about price and utility.

Let’s suppose Fred had five pieces of gold. Let’s suppose that Fred knew Barney would give him a club for ten pieces of gold and that Murray, who decided not to follow his doctor’s orders, would exchange five pieces of gold for a box of brontosaurus burgers. Obviously, Fred’s best course of action is to sell the burgers to Murray and then take the ten pieces of gold to Barney’s and buy a new club. We could say that one club cost two boxes of burgers, and indeed it did. We also could say that one club cost ten pieces of gold (or ten dollars if dollars happen to be the common medium of exchange), and we usually do. In other words, the price of a good can be expressed in terms of any other good for which it can be exchanged, or it can be expressed in terms of money. Remember, money is a commodity in most respects like any other commodity.

Now, is one club really worth two boxes of burgers simply because Barney said so?...Of course not.

Remember, it takes two to make a trade. A trade takes place when and only when there is disagreement on the utility of the goods exchanged. In fact, there is no such thing as fair value or true value in an economic sense. The market is nothing more than a series of trades among individuals who disagree as to the utility of the goods or services traded.

You now know all you need to know about what prices are and how they reflect the basic needs of the individuals who come to the markets. But what causes prices to be one thing and not another? What can we say about how objective prices are discovered?

Stay tuned…

The Speculator’s Edge,

Albert Peter Pacelli