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Commodity hoarding and speculation

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FlyingAxe posted on Sun, Apr 22 2012 6:15 PM

Imagine we have a small oasis, where there is a limited amount of farming. Farmers who grow wheat come to the markets to sell it. A rich person buys up all the wheat (or a lot of it) and hoards it to create an artificial increase in scarcity. When the prices rise, he sells it slowly, but now many poor people cannot afford it. Therefore, the argument goes, such activities should be banned.

Where is the flaw in this argument from economic point of view (i.e., leaving natural rights aside)?

There have been a few reports in the media recently linking rise in medicine prices and availability to speculators buying off medicine and hoarding it. I have seen somewhere the argument that "prices prevent hoarding". But how does it work exactly? Even assuming that presently there are other reason contributing to medical supplies' scarcity and soaring prices, wouldn't hoarding also contribute to that?

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FlyingAxe:
Another question (courtesty of my wife): isn't it a known fact that diamond producers (those who buy African diamonds and then clean and polish them) hoard the diamonds to make sure that the prices don't go below a certain point?

De Beers: A Free-Market Cartel?

 

Is that because the prices won't ever rise enough for him to recoupe the losses and make profit? Why? I don't really know how supply-demand curves, etc., work, so is there a link to an explanation that would show how the curves and the accompanying prices will shift?

For supply and demand curves, see here.  But to answer your question, basically yeah, it's like I said, he has to worry about people getting their supply from a competitor, or switching to a substitute product, or simply not buying it.  And in your specific scenario, he also has a time constraint because wheat has a shelf life (i.e. it will rot...meaning he can't take forever to sell).

Again, I would also recommend you see the link on predatory pricing.

 

If the harvest is in the fall and the planting is the early spring, he has a year to make profit from the higher prices. When the next year comes, he will have made profit and can actually invest his money again in a similar operation.

If this guy sees enough of opportunity to profit from this community, what makes you so sure someone else wouldn't see the same opportunity and come in to meet a demand...that is, why exactly would not another opportunist come in with his own wheat supply and undercut the monopolist?

 

But this story makes no sense. If the Germans were able to sell bromine at 27 cents in the US (a price which Dow could not match), why didn't they just sell it for 27 cents in Europe (where he would definitely not be able to match this price) and drive him out of European business (the standard model of predatory pricing)?

Because that price was such a loss that they would not be able to remain in business themselves for very long.  They need to be able to keep making the bromine if there is any purpose in them trying to put someone else out of business.  If you sell your entire revenue stream at a loss, where in the heck are you going to get the resources to continue making the product?

Again, see the link on predatory pricing.

 

Well, he can buy off enough medicine to drive the prices up and then slowly sell the medicine back (imagine it takes a long time to replenish the stock of this medicine to drive the prices back down), making the profit on the amount the prices went up minus expenses for shipping/storing. Why won't this work in all cases?

Again, because the market finds a way to meet demand.  People will find a substitute product, or another supplier will emerge, or the customers will simply buy less (or there will be less customers)...basically less volume sold.

Again the only way you can make something like this work is when you have government force to sure up your monopoly.  See here.

 

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We went into this a bit starting about here in this thread.  The idea of "cornering a market" is largely a myth.  The amount of resources it would take to do that are immense, and if you look at that thread, you'll see how even examples that are offered of this supposedly happening are bunk.

This is basicallly the "predatory pricing" myth.  For a lot of economic explanation, see here.

But in your situation, for one, just as in any other situation, as more and more of the supply gets purchased, the price rises.  So the "predator" will not only have to have the resources to pay the higher prices, but he'll have to sell them at a high enough sustained premium to recoupe all those losses.  This is essentially not feasible in any realistic scenario.

Another point is, if this is such a small community with such limited farming, one would have to assume it has limited everything else.  Where did this guy get all the wealth to purchase the entire stock of the commodity?

Something else to consider is, why can't people just switch to barley?  Or some other substitute good?

What's more, again, if it's such a small community, and they're so worried about being gouged, why did the small number of sellers sell all their stock to the one guy?  They could easily refuse.  You see this all the time in retail shops.  When they offer sales they regularly limit the purchase to a certain number of items per customer.  This is because the sale price is obviously not enough to compensate the retailer for the sale.  It's what's called a "loss leader"...a product used just to get people into the store in hopes that they will buy other things.  Sellers don't have to sell anyone anything.

And one last thing...by the time he would be able to sell all of it at the high price he would need to to actually earn a profit worthy of such an investment, people would have found a way to largely deal without the product...and quite probably, more supply would have been harvested.  So in essence, there's really no way for the guy to recoup his initial expenditures (again, assuming he had such wealth to begin with), so he would basically be wasting his money.  Tom Woods recounts a great example of an attempt at "predatory pricing" backfiring.

And the idea of buying off the entire supply of medicine or medical supplies is just insane.  What is much more likely is IP protections (in this industry, usually patents) are used to monopolize and restrict supply by having the government cover the cost of preventing competition...as in, threatening potential competitors with violence and theft.

There was a great documentary on Australian television that covered this very issue.  Patently a Problem.  The trailer is here, and the full film is here.

One more great argument against IP.

 

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If he has bought up the entire market supply for a certain time period, he is only going to get his maximum benefit (revenue) by selling all of it.  He might be able to get away with some price discrimination (selling more to the people with a higher demand for it), but he's not going to benefit from having any excess supply.  So, no matter what, no less wheat will be sold than if he had never bought it in the first place.  If there are people who can't afford the wheat at its current price, and he still has excess supply, he's going to lower the price until it's sold off.  Even if the cost of storage were 0, he wouldn't benefit from having wheat that no one's going to buy.  Think of it this way: if the farmers produced 5000 units of wheat for time period X, that's how much they want to sell.  If he buys it all, why would he want to sell 4500 units and then stop?  He wouldn't.  It makes no sense to say that less wheat would be sold in the situation with the rich hoarder than in the situation without him.  He might make more money if he is able to temporarily act as a "monopoly seller", but he does not have control over the production before he buys it.

I hate these isolated scenarios because they're so unrealistic and misleading, but the problem which is alleged to arise here is impossible with economically rational actors.  I'm sure I missed something, but the allegation that this would lead to less wheat being sold than otherwise is false.

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Before I answer to the specific questions, let me offer this scenario which I was discussing with my wife:

Let's imagine a new drug has been produced. Some rich speculator goes to the pharmaceutical company that has produced it and offers to buy 50% of the stock at 110% price. As a result of the new drug shortage, the price for the drug goes up to 120%. The speculator then sells off the hoarded drug slowly and makes 10% of the price as a profit.

Why won't this work? I watched the video by Robert Murphy about the speculators. Does the above scenario work only when there will be a decreasing supply of the drug in the future?

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FlyingAxe:
Does the above scenario work only when there will be a decreasing supply of the drug in the future?

...and if there are no substitutes, and if the demand for the product is not very elastic.

 

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Another question (courtesty of my wife): isn't it a known fact that diamond producers (those who buy African diamonds and then clean and polish them) hoard the diamonds to make sure that the prices don't go below a certain point?

 John James:

So the "predator" will not only have to have the resources to pay the higher prices, but he'll have to sell them at a high enough sustained premium to recoupe all those losses.  This is essentially not feasible in any realistic scenario. 

Is that because the prices won't ever rise enough for him to recoupe the losses and make profit? Why? I don't really know how supply-demand curves, etc., work, so is there a link to an explanation that would show how the curves and the accompanying prices will shift?

 Another point is, if this is such a small community with such limited farming, one would have to assume it has limited everything else.  Where did this guy get all the wealth to purchase the entire stock of the commodity? 

He is someone who arrived in the community from elsewhere, hoping to profit.

 What's more, again, if it's such a small community, and they're so worried about being gouged, why did the small number of sellers sell all their stock to the one guy?  

Well, the farmers don't care. They stockpiled enough grain for themselves. And they got a nicer profit from selling to this guy than at the market price.

 And one last thing...by the time he would be able to sell all of it at the high price he would need to to actually earn a profit worthy of such an investment, people would have found a way to largely deal without the product...and quite probably, more supply would have been harvested.  

If the harvest is in the fall and the planting is the early spring, he has a year to make profit from the higher prices. When the next year comes, he will have made profit and can actually invest his money again in a similar operation.

 Tom Woods recounts a great example of an attempt at "predatory pricing" backfiring. 
I remember listening to that example, and I didn't understand this story. Dow was selling bromine for 36 cents a pound in Europe, while the Germans were selling it for 45 cents a pound. In order to drive him out of business, the Germans decided to sell it for 27 cents a pound in the USA, a price that Dow could not match. So, the story goes, he tricked them by buying the bromine they sold in the US and re-selling it in Europe.

But this story makes no sense. If the Germans were able to sell bromine at 27 cents in the US (a price which Dow could not match), why didn't they just sell it for 27 cents in Europe (where he would definitely not be able to match this price) and drive him out of European business (the standard model of predatory pricing)? This sounds like a story of predatory pricing backfiring because the people doing it were idiots. (If all the facts in the story are correct.)

 And the idea of buying off the entire supply of medicine or medical supplies is just insane. 
Well, he can buy off enough medicine to drive the prices up and then slowly sell the medicine back (imagine it takes a long time to replenish the stock of this medicine to drive the prices back down), making the profit on the amount the prices went up minus expenses for shipping/storing. Why won't this work in all cases?

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 Rorschach: He might make more money if he is able to temporarily act as a "monopoly seller", but he does not have control over the production before he buys it.

Exactly, he makes money as a monopoly seller. He does not have control over production, but there is no production of wheat between the time he buys it (in early fall, right after the harvest) and almost a year from then (the next harvest).

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FlyingAxe:
Another question (courtesty of my wife): isn't it a known fact that diamond producers (those who buy African diamonds and then clean and polish them) hoard the diamonds to make sure that the prices don't go below a certain point?

De Beers: A Free-Market Cartel?

 

Is that because the prices won't ever rise enough for him to recoupe the losses and make profit? Why? I don't really know how supply-demand curves, etc., work, so is there a link to an explanation that would show how the curves and the accompanying prices will shift?

For supply and demand curves, see here.  But to answer your question, basically yeah, it's like I said, he has to worry about people getting their supply from a competitor, or switching to a substitute product, or simply not buying it.  And in your specific scenario, he also has a time constraint because wheat has a shelf life (i.e. it will rot...meaning he can't take forever to sell).

Again, I would also recommend you see the link on predatory pricing.

 

If the harvest is in the fall and the planting is the early spring, he has a year to make profit from the higher prices. When the next year comes, he will have made profit and can actually invest his money again in a similar operation.

If this guy sees enough of opportunity to profit from this community, what makes you so sure someone else wouldn't see the same opportunity and come in to meet a demand...that is, why exactly would not another opportunist come in with his own wheat supply and undercut the monopolist?

 

But this story makes no sense. If the Germans were able to sell bromine at 27 cents in the US (a price which Dow could not match), why didn't they just sell it for 27 cents in Europe (where he would definitely not be able to match this price) and drive him out of European business (the standard model of predatory pricing)?

Because that price was such a loss that they would not be able to remain in business themselves for very long.  They need to be able to keep making the bromine if there is any purpose in them trying to put someone else out of business.  If you sell your entire revenue stream at a loss, where in the heck are you going to get the resources to continue making the product?

Again, see the link on predatory pricing.

 

Well, he can buy off enough medicine to drive the prices up and then slowly sell the medicine back (imagine it takes a long time to replenish the stock of this medicine to drive the prices back down), making the profit on the amount the prices went up minus expenses for shipping/storing. Why won't this work in all cases?

Again, because the market finds a way to meet demand.  People will find a substitute product, or another supplier will emerge, or the customers will simply buy less (or there will be less customers)...basically less volume sold.

Again the only way you can make something like this work is when you have government force to sure up your monopoly.  See here.

 

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Wheylous replied on Sun, Apr 22 2012 10:01 PM

When the prices rise, he sells it slowly

So the rich guy is extorting an island of subsistence farmers? Makes little sense to me.

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Wheylous replied on Sun, Apr 22 2012 10:19 PM

If he has bought up the entire market supply for a certain time period, he is only going to get his maximum benefit (revenue) by selling all of it

I loved your clear explanation. However, I see a problem with it, and this may be due to me using neoclassical equilibrium theory to analyze the situation here.

In neoclassical theory of markets, there is price elasticity of demand. That is, there is an amount which the seller would like to sell that would maximize his revenue - the unit elastic point. The revenue is seen as the rectangular area below the point along the demand curve at which you sell.

Using neoclassical theory, there is a point at which the seller would not want to sell more.

However, this relies on the idea of equilibrium and homogeneous prices.

Is the reason that all the wheat needs to be sold off to maximize profit due to the fact that there is price discrimination going on (and hence no one set price to calculate the area under the curve; he just incrementally decreases price as he finds no buyers at the current level) or are you wrong?

 

Maybe I should be using marginal pairs instead of neoclassical equilibrium.

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Clayton replied on Sun, Apr 22 2012 10:59 PM

I think JJ cleaned up on this one but I want to underscore the point that when the hoarder goes to sell off his horde, the price will fall and there is no guarantee that by the time he has sold his last unit, the price will not have fallen very much. Depending on how the price falls as he's selling off his massive hoard, he could easily end up losing money. Hence, even buying up 100% of the market is still a speculative act.

In fact, there is an industry where this kind of thing happens all the time: the fine art market. Each Rembrandt is absolutely unique - it is 100% of its own market. At millions of dollars a pop, there is nothing wrong with thinking of a single painting as an entire market. But just buying a Rembrandt is no guarantee that you'll make a profit. Art collecting is inherently speculative. And think about the reasons why a Rembrandt owner can lose money - there are alternatives to his market. Sure, Bill Gates may really, really want that Rembrandt self-portait you have, but if you won't lower your price to a reasonable number, he'll just learn to do without and buy a more reasonably priced piece of art instead.

Clayton -

http://voluntaryistreader.wordpress.com
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Why would the prices not drop down to the original level? Because the consumers found a way to do without the product?

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