Hal Varian makes a persuasive argument and does us all a great service with his Economic Scene column in today’s New York Times (registration required). He focuses on two specific aspects of the workings of oil and gasoline markets: storage arbitrage and the role of speculators.
Storage arbitrage explains why, even if you have gasoline in storage that you paid a lower price for, you’ll still raise your price to buyers. Your incentive to do that is independent of whether or not the market in which you operate is competitive, an oligopoly, or a monopoly:
To spell out the argument, imagine that you own a storage tank full of gasoline that is currently worth $2 a gallon at wholesale prices. It is widely believed, however, that the price of gasoline will be $2.10 next week.
You would be crazy to sell your gasoline now: just wait a few days and the higher price will be yours. But if everyone waits a few days, there is no gasoline to be sold now and the resulting shortage pushes the price of gasoline up.
How high does it have to go? The answer is $2.10 a gallon. That is the price necessary to induce those who have gasoline to sell it now rather than to wait till next week.
This argument does not depend on whether you think the gasoline market is a paragon of perfect competition or an evil oligopoly. All it requires is that you believe that people who own gasoline, like just about everybody with something to sell, prefer to receive a higher price rather than a lower price.
Varian also debunks the idea that ill-informed and naive speculators will contribute to systematic increases in the prices of commodities like oil; sure, they may push prices in one direction or another in the short run, but if they don’t profit they will exit. Thus the involvement of speculators in the market actually serves to stabilize prices; they are part of a self-regulating system. He reminds us that Milton Friedman made this argument long ago, and that notwithstanding some criticism, his argument has been borne out:
Mr. Friedman’s argument was applied to currency trading, but the same reasoning works here. If speculative trading tends to push prices higher when they are already high and lower when they are already low, then traders must be buying high and selling low.
That would mean that traders have to lose money on average — which does not seem very likely. To the contrary, speculative traders try to buy low and sell high, activities that by their nature tend to push prices up when they are too low and down when they are too high.
Yes yes yes.