In my Principles of Microeconomics class, when we’re discussing the role of prices and of speculation, I share with my students the following story (as recounted in this September 2008 letter to the station manager of WAMU radio in DC):
This morning your reporter interviewed a resident of Galveston, Texas, about the effects of hurricane Ike. The person interviewed said that she went to the gasoline station before Ike hit to “top off” her tank. But she was angry to find that gasoline prices had jumped 50 cents per gallon from the day before. “It’s ridiculous,” this woman opined. “Ike hadn’t hit yet!”
Your reporter should have immediately asked this woman: “Well, why were you topping off your tank? Ike hadn’t hit yet.”
Gasoline became more scarce — more precious — in Galveston the moment Ike’s arrival became likely. Gasoline retailers acted in anticipation of the future no more or no less than did motorists (such as your interviewee) who topped off their tanks.
Donald J. Boudreaux
While no one has explained the beneficial role played by speculators better than has Adam Smith, I below try a somewhat different way to explain the importance of the fact that market prices accurately reflect not only the market conditions that exist today but, also, the market conditions that are likely to exist tomorrow.
The degree of scarcity of a good (relative to consumer demand for that good) is determined not only by how much of that good is available in the present but, also, by how much of it will be available in the future. The scarcity of a good (or service) exists in both a spatial and a temporal dimension.
The degree of scarcity, for example, of petroleum cannot accurately be determined by looking only at the amount of that oil that exists in one particular geographical location, such as Texas or Russia. To get a more accurate assessment of the scarcity of petroleum requires taking account of the amount of petroleum in existence in all geographical locations. But, again, the spacial dimension is only one dimension in which goods exist. Goods exist also in a temporal dimension. So to get today the most accurate assessment of the scarcity of petroleum requires an examination of supplies of oil not only across different geographical locations but also across different temporal locations (today, tomorrow, the next day, and so on).
Just as the marginal value of a barrel of oil located in Texas will be higher or lower the lower or higher are supplies of oil located outside of Texas, the marginal value of a barrel of oil located in ‘Today’ will be higher or lower the lower or higher are supplies of oil outside of ‘Today’ (such as, for example, in ‘One Week from Today’). Just as no one with any sense demands that the pricing of barrels of oil in Texas be done in ignorance of the relative scarcity of oil outside of Texas, no one with any sense demands that the pricing of barrels of oil in ‘Today’ be done in ignorance of the relative scarcity of oil outside of ‘Today.’
In short, the value of a good today depends every bit as much upon the relative scarcity of that good in ‘Tomorrow’ as it does upon the relative scarcity of that good in ‘Today.’ Given this reality, we want the price of the good today to depend every bit as much upon the relative scarcity of that good in ‘Tomorrow’ as it does upon the relative scarcity of that good in ‘Today.’ Speculation is by far the best means that humans have stumbled upon to ensure maximum possible consideration of the relative scarcities of goods across time.
Imagine an oceanside village whose residents’ only food is shipped in regularly on boats. Every Monday morning one boat sails into the village’s harbor. Each boat is packed with enough food to feed the villagers quite generously for seven days. These food-bearing boats have been arriving regularly, without fail, every Monday morning for the past 100 years.
One Monday at noon, however, just after completion of the unloading of the food cargo on that Monday’s boat, a reliable source brings terrible news to the villagers: the next two food-bearing boats scheduled to arrive – one next Monday, the second on the Monday after that – have sunk. They’re not coming. The next food shipment, therefore, will not arrive until three weeks from today.
What happens to the value of the food in that village the moment the news about the sunk boats sinks in? Answer: it goes up. The value of the food rises despite the fact that nothing yet has changed the villagers’ food supply. The amount of food the villagers have on hand when they get this awful news is no different from what it would have been had this news not been delivered or had the incoming boats not sunk.
How would any sensible person, upon learning this bad new, advise the current supply of food be treated? Surely that person would advise that the rate at which the food on hand is consumed be reduced. For the villagers to survive, they must make the current stock of food last, not one week, but three weeks. A rate of consuming food that would have been perfectly appropriate if there were no pending disruption in the delivery of food becomes excessively high given that the villagers’ future food supply now is known to be lower than it had been in the past. Sensible people understand that the rate of food consumption must be reduced now rather than waiting until one week from now before reducing that rate of consumption.
And no sensible person would take seriously any villager who protested that she should await the non-arrival of next-Monday’s food boat before she reduces her rate of consuming food. No sensible person would give the slightest bit of credence to this woman’s argument that, because no expected food shipments have as of now not arrived, food is no more scarce today than it has been in the past.
The price changes brought about today by speculators are (1) the signal that future supplies will be different than previously expected and (2) the incentives for consumers to start today to appropriate take into account tomorrow’s fall in supply of the good (and (3) both a signal and an incentive for suppliers to put forth greater efforts to increase supplies in the future).
(Scholars of Adam Smith will note that my food-boat example is similar, although not identical, to an analogy used by Adam Smith to make the same point. See paragraph 42 here.)