Part 2 of post on the effect of speculators:
Suppose the price of a commodity is expected
to jump up at a specific time in the near future.
Speculators will realize they have an opportunity
to earn profit: they will buy the product now
at the current price, and then they can sell it
after the price shoots up. As shown last time,
when many people try to do this the price of the
product will tend to rise at the same rate as the
rate of interest.
After the event happens that would have caused
the price to jump, the speculators will now sell
their hoard. They will have tried to purchase
just the right amount so that they can keep
selling the product until its price rises
up to the level it would have reached
after the jump. This figure illustrates
the gradual rise in price when the market
has the speculators, and the sudden jump in
the price that would happen if there were
no speculators.
The important point here is that the speculators
perform a useful service to society. They can’t
protect society from the increase in the price,
but they can protect us from the sudden jump
in price. The effect of speculation is to
make the price increase more smoothly gradual,
which will make it easier for society to adjust
to the higher price. So speculators maybe deserve
more credit than they typically get.
However, there is a catch. The preceding analysis
assumes that the speculators’ expectations are
correct. Now suppose that they expect the price
will increase next month, but instead the price crashes.
This figure illustrates how the speculators
have made the market more volatile, by causing
the price to increase before the crash, and then
by causing it to fall lower than it would have
otherwise because the speculators are trying to
sell off their stockpiles. The implication
is that incorrect speculation makes markets
more volatile and hurts society. The speculators
do lose a lot of money if they have guessed wrong,
so in that sense they pay the price for the
damage they cause and they have a strong incentive
not to do that.
……………..
–Douglas Downing
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