## Sunday, April 22, 2012

### Speculation: A hypothetical example

Suppose a horrifying hurricane, Hurricane Adam, is barreling toward the metropolitan area of Las Smith, which has one million people, comprised exactly of 250,000 families of four.  In exactly one week, Hurricane Adam will make landfall and wreak unthinkable devastation -- devastation so bad that all one million people have been ordered to evacuate to the nearest safe haven, 200 miles away.  Between now and 7 days from now, they must evacuate or face doom.

To carry out this evacuation, each of the 250,000 families needs to buy enough gasoline to make a 400 mile trip (200 away, 200 back) for a total of 100 million car miles.  Suppose that each car in Las Smith gets 20 miles per gallon.  Hence, the evacuation will require 100 million / 20 = 5 million gallons of gasoline.  For the sake of this post, suppose this is 5 million extra gallons of gasoline beyond what the residents would consume otherwise.

Where does this gasoline come from?  The market provides an answer.

Because of Hurricane Adam, the residents of Las Smith have extra demand for gasoline.  In an overly stylized market for gasoline, an increase in demand raises the price for the product.  At a higher price, everyone has an incentive to conserve (if they can afford to conserve), and some cut back.  In equilibrium, the rest of the market cuts back on gasoline consumption by 5 million gallons, and the residents of Las Smith have gasoline available for their trip.

Notice another thing: the people who cut back are those who value the gasoline the least.  Turn this on its head: the price goes up and people who value the gas least don't consume it.  It's a simple insight, but one that describes the power of the market to promote efficiency.  Hayek describes this decentralized process in The Use of Knowledge in Society in much greater detail.

For a more interesting application, think about our ability to store and ship gasoline.  In Chicago, I can cut back on my driving today, and my cutting back can make available some gasoline one week from today in Las Smith.  If only there were a mechanism to get me to cut back... This is where speculators come in.

If the price of gasoline in Chicago does not adjust today, a speculator who buys gas from Chicago today and ships it to Las Smith before next week will be rewarded (technically, you have to cover the shipping costs, but you get the point).  After all, today gas is cheap in Chicago while the residents of Las Smith will pay more.  A profit-seeking speculator will buy gasoline from Chicago today and ship it to Las Smith next week as long as it continues to be profitable.  The very act of buying gas today in Chicago will drive the price up now in Chicago.  On its face, this seems odd, but there is good reason for the price to go up immediately.  The gas is needed less now in Chicago than it is a week from now in Las Smith.  In this story, the speculator moves gas from where it is needed least to where it is needed most.

This description of the gasoline market is stylized -- in reality, there are more than two locations, and more than two time periods -- but hopefully, the simplicity of the example shows what role speculators play in more general settings.  Speculators can make profit when they move the objects of speculation from low demand states to high demand states (that's how they can buy low and sell high).

For much more, including the inspiration for this simple example, check out James Hamilton's excellent post on the matter.  In closing, here's an excerpt:
Here I have a modest suggestion. If Representative Kennedy knows a way to go out and produce another barrel of oil somewhere in the world for \$11 a barrel, he would do a world of good if he would actually go out and do it himself, as opposed to simply asserting confidently in the pages of the New York Times that it can be done. People with far more modest fortunes than Kennedy inherited are out there using their resources to try to bring more of the physical product out of the ground.
And many, many more would be attempting the feat if it were remotely possible to produce a new barrel of oil for anywhere close to \$11.
If you want to prove me wrong, Mr. Kennedy, then don't talk about how easy it is to produce more oil-- just go do it.
In other words, maybe before criticizing speculation, we should all walk a mile in the speculator's shoes.  Not only would we see the difficulty of making money speculating, but we would have a new pair of shoes (and a mile head start).