The Simple Analytics of Commodity Futures Markets: Do They Stabilize Prices? Do They Raise Welfare?*

This publication primarily presents economic research aimed at improving policymaking by the Federal Reserve System and other governmental authorities. Articles may be reprinted if the source is credited and the Research Department is provided with copies of reprints. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. Modern futures trading—the organized trading of contracts to buy and sell things at a later date—began at the Chicago Board of Trade in the 1860s. Since then, the number of futures markets has grown exponentially. These markets strongly influence the prices and quantities of a vast array of foods, grains, livestock, metals, industrial materials, and financial assets. Almost since they began, futures markets have excited debate about whether they make prices more volatile. Organizations representing producers, especially farmers, have argued that they do. This public debate has generated a sizable academic literature. The academic literature has studied futures markets from both empirical and theoretical perspectives. The empirical studies have compared how prices behave before and after the introduction of futures markets. (For a summary of the empirical research, see the references cited in Turnovsky 1983.) Although the empirical results are mixed, they seem to show that the volatility of prices tends to decrease when futures markets are introduced into an economy. The theoretical literature largely stems from Friedman's (1953) argument that speculation necessarily reduces the volatility of prices. The theoretical work suggests that under plausible assumptions about the sources of economic disturbances, futures markets reduce the volatility of prices. (See, for example, Turnovsky 1983 and Turnovsky and Campbell 1985.) It is difficult, however, to know how generally this result applies, since the literature uses very specific functional forms to model the objectives of market participants. In this paper, we clarify the set of circumstances under which futures markets stabilize, or reduce the volatility of, prices. We show that, under a fairly stringent set of assumptions, the introduction of futures markets does stabilize prices. The assumptions we make are stringent, for we can easily construct examples in which they do not hold and in which prices become more volatile when futures markets are introduced. We go beyond this issue, however. We also point out and question an implicit assumption in both the popular debate and the academic literature on the effect of futures markets—the assumption that lower price …