No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Six: Applications in Markets 141 supply will be reduced is immaterial to the speculator. Her only concern is that the price rise will be sufficient enough to justify the costs of buying the oil (or rights to the oil) at today’s prices to sell later. When she and thousands of others are buying oil, the additional demand will cause a shift in the demand curve as seen in Figure 6.7 . Interestingly, this increase in demand is not to consume the oil; rather, it is to hold it for future sale. The demand for current consumption of oil has not changed, and at the higher price the quantity demanded will fall. Earlier in this chapter we reviewed how the market reaction to a hurricane will cause both suppliers and demanders to behave in a socially desirable way; in this case we are reviewing their actions in the case of an unknown issue to see if the effects are stabilizing or destabilizing. Let’s say that the speculators are wrong; the fundamentals that speculators envisioned in the future (either evidenced by an increase in demand or a reduction in supply) do not pan out. They have bid up the prices to $90/barrel in expectation of a profit. Producers have increased production to take advantage of the higher prices, while consumers have reduced their consumption as the opportunity cost of using oil goes up. Inventories will rise, and at some point some of the speculators will begin to see that their estimate of the future was wrong—at that point they will try to sell first at the higher price before the other speculators do. As the price starts to fall, other speculators that bid oil up to $90/barrel will see increasing losses; they too will be forced to sell to cut their losses. Will the price return to $70/barrel? Not initially; in fact, it must go much lower—perhaps to $50 as shown in Figure 6.8 . The consumers were originally forced to pay $90 by the speculation, and now there will be a period of prices well below the equilibrium that the consumers will enjoy. When the speculators are right, as seen earlier in the chapter when a hurricane hit, speculation will ensure that suppliers and demanders take the socially correct action. When they are wrong, both suppliers and demanders will initially respond in the wrong fashion; but as the errors of the speculators become apparent, there will be a return to optimal behavior. Suppliers that initially benefitted from and demanders that were initially hurt by higher prices will see a reversal Figure 6.7, Increase in Demand, due to speculation. An increase in demand due to speculation will result in a higher price and quantity. However, the additional demand caused by speculation is to hold the oil in reserve to sell in the future, not to consume. The actual demand for consumption is still the curve D 1 ; at the higher price driven by the speculative demand, the quantity demanded will fall to Q 2 as shown above. The difference between Q S and Q 2 is the speculative demand. P ($) Q (#) Q 1 90 70 Q 2 S D 1 D 2 Q S Oil Market Figure 6.8, Collapse in speculation. Once speculators see inventories rise and the failure of whatever fundamental factor they expected to occur (either higher demand or lower production), they will begin to sell to minimize losses. Given the higher production at Q S , prices will fall initially to $50/barrel, far lower than the final equilibrium price of $70. P ($) Q (#) Q 1 90 70 Q 2 S D 1 D 2 Q S Oil Market 50