How do Speculators make money?

Speculators make money by arbitraging away price differences. They smooth out price differences. Do they always accurately predict when prices will rise or fall? Of course not, but if they guess wrong about this, they lose their money. Over time speculators have proven remarkable accurate at making these predictions and the loses that they risk from guessing wrong definitely gives them strong incentives to get things right.

Now comes the notion of taxing financial transactions to reduce the return to speculation (link to Paul Krugman). What this tax will do is increase price swings over time. Suppose that the transaction costs of buying and selling oil as well as storage costs come to 10 cent a barrel. In that case, you would have to expect the price to rise by a dime before it would pay for speculators to arbitrage away any expected price increase. Now suppose that you add a tax of 20 cents. Well, of course, the increase in price would have to be 30 cents before speculators will act to limit the rise. Is that good? As usual, Krugman's piece doesn't have what amounts to economic reasoning to defend his position.

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Blogger Jim W said...

Hey, as an economist, I was wondering if you could shed any light on to why Krugman got the Nobel Prize. It always seemed an extremely odd choice since the guy is so obviously political as opposed to economically oriented.

Even to a relative layperson like myself, most of what Krugman says comes across clearly as a bunch of poorly reasoned or supported leftist nonsense.

11/28/2009 12:54 PM  
Blogger Mathew Paust said...

Jim - After Obama's prize, how can anyone ask such a question? Politics? Perish the doubt! ;>|

11/28/2009 5:20 PM  

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