What is speculation? And does an economy need or benefit by having individuals speculate? These are two important questions that need to be answered in order to understand the vital role speculators play in a dynamic economy. First, the question what is speculation? The definition I am referring to here is "engagement in business transactions involving considerable risk but offering the chance of large gains." However, everyone 'speculates' even in very small ways. Some of us make sure to fill up this week when we think gas is going to go up next week. Sometimes we succeed and gas does indeed go up next week which in effect saves us money. But, sometimes we fail, and gas actually goes down next week. If we were to have waited a week to fill up we might have saved a little bit of money. This is the basis of what speculation is. Now the important question is "does an economy need or benefit by having individuals speculate?" Here is where it gets a little bit more in depth.
Many people, professional and non professional alike, invest in things such as company stocks. When someone buys a stock of a new up and coming corporation they are hoping the stock will increase in value, giving the investor a good return on their investment. As an example, among many, is the internet company Amazon.com which rose in price for years before the company actually made any real profits. The idea for speculators in this example is to buy Amazon.com stock early in the hopes that the stock will go up, whether or not Amazon.com actually makes any profits or not. This allows the initial investors to make a profit.
Businesses speculate all the time as well. To take pharmaceutical companies as an example; a pharmaceutical company can spend millions of dollars developing a new drug all in the hopes that they can one day go out and sell that drug to the general public and make a profit. These companies never have a guarantee they will make anything back, they just have a hope and a good enough knowledge in their areas of expertise to make an educated guess. Something many people don't realize about pharmaceutical companies is they often fail to create or find anything of significance in their research. This is all failed speculation, but once there is something that is found, this is where the profits come in. Once a company develops a new drug and is able to pass all the regulations it is time to start production and make a profit. In the case of pharmaceutical companies they have a bottom line which they have to sell a certain amount of this drug at a certain price to make a profit and thus make their hard work, and all their failures, worthwhile. This is speculation at its best.
There are numerous other examples in every industry. A more easy and fun one to understand is movies. Every movie costs a certain amount to make. These costs are things like 'speculating' that a script one company purchases is going to be a hit. Movie studios also speculate by paying a big star lots of money in the hopes they will draw a big enough audience to make their enormous salaries worthwhile. To use some recent examples of failed speculation in the movie industry, let us use two recent movies, The Love Guru and The Happening. The Love Guru starring Mike Myers, Jessica Alba and Justin Timberlake, is a movie about a man named Pitka who is an American raised outside of his country by gurus. Pitka Returns to the States in order to break into the self-help business. His first challenge: to settle the romantic troubles and subsequent professional skids of a star hockey player whose wife left him for a rival athlete. Although Mike Myers has a large fan base now, a plot like this is not what people were looking for in this now very volatile movie industry. The Love Guru cost 62 million dollars to make. In three weeks at the box office it grossed a mere $29 million and some change. Rendering it almost impossible for any Justin Timberlake fans to ignore the fact that each and every single movie he has been in has completely flopped. Now a completely unrelated movie that shows the overall decline of a rather interesting individual's ability to make a great and interesting movie is M. Night Shyamalan in his latest movie The Happening. This movie which cost over $60 million to make grossed in 4 weeks only 62 million with huge declines every week. While this movie technically made a profit, movie executives are going to be rather edgy about signing any 60-80 million dollar contracts with Mr. Shyamalan in the future. Track records can be very important in speculation.
As is hopefully very clear by now, speculation is something that the average Joe can involve himself in as well as professional speculators. A professional speculators main role is in relieving other people from having to speculate as part of their regular economic activity. Put differently risk is inherent in all aspects of human life. Speculation is one way of having some people specialize in bearing these risks, for a price.
At this point it is very important to understand the difference between speculations and gambling, which is what many individuals like to consider speculation. Gambling simply creates a risk that would otherwise not exist, such as Russian roulette. These games are usually conducted to either profit or just simply to show off one's own skill or lack of fear. Economic speculation differs in that it deals with inherent risks in such a way as to minimize it and to leave it to be borne by whoever is best equipped to bear it. In other words it deals with risks that are a fact of life so to speak, and speculation allows these risks to be shouldered by men and women who are experts in dealing with such things.
To quote Thomas Sowell in his book Basic Economics where Mr. Sowell gives an example of commodity speculators and their importance to the market, using wheat.
"When a commodity speculator offers to buy wheat that has not yet been planted, that makes it easier for a farmer to plant wheat, without having to wonder what the market price will be like later, at harvest time. A futures contract guarantees the seller a specified price in advance, regardless of what the market price may turn out to be at the time of delivery."
What this does in essence is to separate farming from speculation, or mining from speculation etc. It allows the farmer to concentrate on what he does best, farming, while allowing a speculator to concentrate on what he does best, speculate. Each can benefit from the other. Let us say this farmer, who has to deal with wheat from all over the world, plants crops in the hopes of being able to sell his crop at $150 a bushel. Now with the market having such vast ups and downs which depend on everything from war and famine to drought, it is hard for one farmer to be sure what he may be able to gain from this season of harvesting. Instead of worrying about it, this farmer may decide to sell his crops to a speculator for $90 a bushel and guarantee a profit. Some may believe that the speculator is profiting off of the farmer, but they ignore the fact that now the farmer has a guaranteed profit whether or not he would have actually made a profit. Let's say the price of wheat actually goes down because of bumper crops all over the world, and now it is trading at $30 dollars a bushel. If the farmer had not 'purchased' the speculators services he would have lost $20 dollars a bushel (assuming it cost the farmer $50 dollars a bushel to plant and grow the wheat) and is possibly forced to sell his farm, thus leading to less wheat being produced the next year.
A rather important aspect and cost of speculating besides the money itself is also worry. Some individuals are simply not cut out for industries which have such an enormous amount of volatility in them. When a farmers livelihood hangs in the balance, as is shown in the above example of selling wheat at $90 dollars a bushel, may appeal to a farmer who knows he now doesn't have to worry about what might happen if the price drops and he loses money. In other words he leaves the future risk in the hands of the professional speculators, and the professional speculators leave the planting and harvesting of crops in the hands of farmers.
It is important to understand that without profit there would be no one willing to bear such a heavy burden, that of risk. It is because profits can be so high that many people begin careers in speculation, while at the same time it is because of the high risk nature of the industry that many people also stay away.
Just like any other industry speculators have to compete with other speculators, so this brings up the question of whether or not the service rendered is worth the price charged. Farmers are able to on a one on one basis decide if the price is worth it or not. If the farmer believes the price will go up he has every opportunity to bear the cost himself and take that chance. However, since every speculator must bid against other speculators, which is no different than each farmer competing with every other farmer. Competition, as always, determines the prices speculators are able to charge for their services. If that profit exceeds what it takes to entice investors to risk their money in this volatile field, more investments will flow into this segment of the market until competition drives profits down to a level that just compensates the expenses, efforts, and risks. It is easy to actually understand this frantic competition when looking at commodity exchanges between people shouting in a large room on Wall Street or other similar places. Some farmers do indeed speculate in their own crops which gives them more control over their financial future. But, the majority of farmers are going to try and make sure they are guaranteed a profit, and therefore sell to speculators. In the end it is up to the farmer whether they believe the service is worth the price being charged.
The major debate of our current presidential election is now Gas Prices. One scapegoat is the speculators, it is easy to see the evil of a speculator, since they work purely for profit, and profit is evil. However, In order for a speculator to actually affect the oil market in any significant way he or she would have to purchase extreme amounts of oil and keep it off the market, thus driving the price up, and sell later at a higher price. Since there is no evidence of this happening, nor will there ever be just because it's not economically viable, this is pure "speculation," and bad speculation at that, speculation without any evidence or analytical proof. If we think about it there is only one group that is actually 'hording' oil and keeping it off the market for the future. That group is the government, especially the United States government with reserves of oil in excess of one billion barrels of oil.
As far as greed goes, editor of The Intellectual Activist Paul Blair states:
"The idea that speculation is causing higher prices just boils down to the idea that prices are going up because certain greedy people want them to go up. But if people could raise prices just by wishing, why weren't prices already skyrocketing ten years ago? Why aren't they always skyrocketing in every market? Why don't the speculative short sellers greedily lower the prices simply by wishing them to go lower?" (http://www.capmag.com/article.asp?ID=5224)
Lastly, in an article by economist Walter Williams titled "in defense of Oil and gas speculators," Mr. Williams eloquently explains the importance of speculation using corn futures.
"Say that today's price of corn is $7 a bushel. I have a hunch that because of Midwest flooding, higher demand due to droughts and war in other parts of the world, that in may 2009, corn will sell for $12 a bushel. I stand to make a lot of money by buying corn now for $7 a bushel, holding it, and in may 2009 selling it for $12 a bushel. If many speculators share my hunch and buy more corn now, today's price, sometimes called the spot price, is going to rise let's say to $10 a bushel."
The way this effects the economy is in a very positive long term way. Mr. Williams goes on to explain that if the government were to outlaw the corn futures market or make them more costly, then this might cause the spot price to be lower, possibly bringing it all the way back down to $7 a bushel. The question to ask is this; "What happens in May 2009?"
Let's say all the horrible things that we hoped would not happen, did indeed happen. Midwest flooding caused an enormous dip in supply, and demand goes up because of war and drought in far off places in the world. Since congress outlawed or made it more costly to trade in corn futures the (May 2009) prices are going to be much higher since there will be much less corn on the market and more of a demand. The important thing to remember is that if congress had not interfered people would have used less corn now (because of higher current prices), which would allow there to be more corn in the future (May 2009). This illustrates the most important aspect of speculation, the allocation of resources over time. Congress in essence allowed Americans to ignore the future.
This is the very core of the importance in speculating. It is of vital importance to take the future into consideration when consuming today. This is the entire reason for prices, higher prices help to curb demand and also increase incentives to bring up supply. This is exactly what is happening with oil right now, as demand is increasing (India, china) Americans and others worldwide are curbing their consumption. At the same time, oil companies are increasing investment into more drilling and better refining techniques.
The oil problem the world is currently undergoing is the same economic principle that has always affecting the world, supply and demand. The answer is to have less government intervention, not more. Allow the market to work the way it was intended, without politicians interfering.
What would lower the long-term price of oil is for Congress to permit exploration for the estimated billions upon billions of barrels of oil domestically available, not to mention the estimated trillion-plus barrels of shale oil in Wyoming, Colorado and Utah. Some politicians pooh-pooh calls for drilling saying it would take five or ten years to recover the oil. I guarantee you we would begin to see a reduction in today's prices even if it took five to ten years for us to get the first barrel. Put yourself in the place of an OPEC member knowing there would be a greater supply of U.S. oil in five or ten years, hence maybe driving oil prices lower to say $40 a barrel. What will you want to do now while oil is $130 a barrel? You would want to sell as much oil now and OPEC's collective efforts to do so would put downward pressures on current oil prices. Right now the U.S. Congress is OPEC's staunchest ally. (Mr. Williams, http://www.capmag.com/article.asp?ID=5221)
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