A Theory of Speculation Relating Profitability and Stability

Abstract

I F a speculator makes profits consistently this implies that he possesses the ability to forecast prices or price changes with a fair degree of success. Whether he thereby stabilizes price is another matter. That is the central problem of this article. The proposed theory relating speculators' profits and the stability of prices is intended to be applicable to those commodities traded on organized exchanges by two kinds of people, cspeculators and non-speculators. What distinguishes speculators from other traders in the market is that their profits depend only on the price or price change of the commodity they trade. Non-speculators' profits are determined not only by the price of the commodity traded on the organized exchange but also by the prices of other related commodities. If the non-speculators are hedgers, they can make their profits almost independent of the price level itself. What enters the excess demand curve of the non-speculators is some weighted sum of the prices of the commodities they handle. How-ever, I shall single out only the price of the commodity traded on the organized exchange when I come to discuss their excess demand. Some examples may make my distinction between speculators and non-speculators clearer. In the cotton market a non-speculator may be a textile manufacturer whose profit is a function of the price of raw cotton, cotton textiles, and other inputs besides raw cotton. By hedging or other means he can avoid taking a price risk and can specialize in producing cotton textiles to maximize his profits. In the foreign exchange market, one kind of non-speculator is an importer whose profit depends not only on the exchange rate, but also on shipping costs, the price of the commodity in the two countries, and the like. He too by hedging can avoid bearing the risk of a change in the exchange rate and can specialize in providing a merchandizing service. However, the stock market is not one for which the theory to be described seems applicable, because no reasonable distinction between speculators and other traders can be made. Perhaps the only non-speculators in that market are those corporations engaged in a new stock issue. In what follows I show that for a fairly general model positive speculators' profits imply that they have stabilized the price. My conclusion is the opposite of that reached by Professor Baumol. In a brilliant article recently published, Baumol gives a counter-example to disprove the proposition that if speculators make profits they necessarily stabilize the price.' After presenting my own model I show why Professor Baumol's results are unsatisfactory.