Market Organization
with Price-Setting Agents
- Last Updated: 12 April 2024
-
Leigh Tesfatsion
- Professor Emerita of Economics
- Courtesy Research Professor of ECpE
- Iowa State University
- Ames, Iowa 50011-1070
- https://www2.econ.iastate.edu/tesfatsi/
tesfatsi AT iastate.edu
-
Home Page for Econ 308
A. What is Market Organization?
An asset is anything of durable value, whether physical or financial in form. Examples include: Apple; computer; battery-stored energy; insurance contract; loan contract; ...
A service is an action taken by an entity that provides benefit to another entity. Examples include: Haircut; health-care; labor; ...
A market is any context in which the buying and selling of an asset or service takes place.
Market Organization is the manner in which exchange in a market takes place. It is determined over time by a combination of factors, including:
- physical and financial constraints (transaction costs, information costs,
production costs,...)
- chance events (e.g., technological discoveries, initial location
choices,...)
- evolutionary forces (adaptations in behaviors, institutions,...)
- goal-directed actions by private individuals (e.g., strategic pricing
practices, entry into the market, exit from the market, collusion,...)
- Goal-directed design by public agencies (e.g., regulations to
enhance market efficiency and/or to reduce market power,...)
B. Two Key Market Player Types: Brokers and Dealers
Key defining aspects of a BROKER:
- A broker facilitates trade in some asset Q (for example, housing, or stock shares)
by matching offers to sell Q (asks) with offers to buy Q (bids).
- The broker does not take a position in Q -- that is, the broker does not
maintain an inventory of Q on his/her own account.
- The broker's profits are determined by the commissions he/she charges to
the users of his/her brokerage services.
- Broker Examples:
- Real estate brokers, stock brokers,...
Diagrammatic Illustration of a Broker:
Payment ----------------- Payment
------------>| |--------->
Bid | BROKER | Ask
(BuyOffer) | | (SellOffer)
| |
<-------------|<----------------|<---------
| (Passed Thru) |
Units of Q ----------------- Units of Q
Key defining aspects of a DEALER:
- Unlike brokers, dealers take positions (i.e., own inventories)
in the asset Q in which they trade.
- Unlike brokers, dealers "make the market" for Q themselves by posting
asks (offers to sell) and bids (offers to buy).
- Thus, dealers are more flexible than brokers in that they don't have to
match sellers to buyers directly -- they can buy Q for holding as inventory
and they can sell units of Q out of inventory.
- Unlike brokers, dealers make profits by buying low and selling high.
- Dealer Examples:
- Retail store owners, new and used car dealers,
Nasdaq stock dealers,...
Diagrammatic Illustration of a Dealer:
Payment ----------------- Payment
------------>|Dealer Dealer|--------->
|Ask Bid|
Buyer | DEALER | Seller
| |
<-------------| Q Inventory |<---------
Units of Q | | Units of Q
-----------------
C. Four Basic Types of Market Organization
- Bilateral Trade (self-organized)
- Over-the Counter (OTC) (managed by dealers)
- Auction (managed by brokers)
- Organized Exchanges (managed by combination broker/dealers)
TYPE 1: BILATERAL TRADE
Key aspect of Bilateral Trade:
Buyers and sellers self-search for trade partners -- there is no intermediary (go-between).
Examples:
- loans sought from friends/family, self-sale of homes,
self-sale of used cars, some job markets
TYPE 2: OVER-THE COUNTER (OTC)
Key Aspects of OTC Markets:
- Managed by dealers.
- No centralized mechanism or facility for trading.
- A public market consisting of a number of dealers spread across a region,
a country, or the world.
- OTC Market Examples:
- Corporate bond markets, Nasdaq stock market, used car
dealerships
TYPE 3: AUCTION MARKETS
Key Aspects of Auction Markets:
- Commonly managed by brokers.
- Some form of centralized facility (clearing house) through which buyers and
sellers execute trades by submission of bids to buy and asks to sell.
NOTE: Depending on context and exact form, bids to buy are sometimes called "demand bids,"
"buy offers," "demand schedules," "demand functions," or simply "demands." Similarly,
asks to sell are sometimes called "supply offers," "supply schedules," "supply functions," or simply "supplies."
-
The "centralized facility" is not necessarily a place where buyers and
sellers physically meet. Rather, it is any facility that provides buyers
and sellers with a centralized access to the bidding process.
- Auctions can either be call markets (e.g. art auctions) for which
bids and asks are all posted at one time, or continuous markets (e.g.
stock exchanges, real estate markets) for which bids and asks can be posted
any time the market is open and exchanges take place continually.
- In economics it is typical to assume that each seller has a (sale) reservation price, i.e.,
a price below which the seller is unwilling to sell. By definition, then, a seller will
only accept a bid from a buyer if the buyer's bid price is at least as
high as the seller's reservation price.
- Similarly, in economics it is typically assumed that each buyer has a (purchase) reservation price,
i.e., a price above which the buyer is unwilling to pay. By definition, then, a buyer will only accept an ask
from a seller if the seller's ask price is no higher than the buyer's reservation price.
Two Basic Types of Auctions:
- 1. One-Sided Posted-Offer Auction
- The protocols (rules) governing the auction are public knowledge.
- If the auction is a SELLER posted-offer auction, the SELLERS
publicly post their asks (offers to sell) in advance.
- If the auction is a BUYER posted-offer auction, the BUYERS
publicly post their bids (offers to buy) in advance.
- Each participant on the OTHER side of the market then tries
to secure the best possible posted offer for themselves, following
auction protocols.
- Examples of Single-Sided Auctions:
- Retail stores, eBay, Priceline,...
- 2. Call Double Auction
- The rules (protocols) governing the auction are public knowledge.
- The auction is conducted through a centralized facility that can take various forms (e.g.,
a human auction manager, or a web screen that automatically processes data input)
- Sellers submit asks to the centralized facility.
- Buyers submit bids to the centralized facility.
- The centralized facility matches these asks and bids in accordance with
the auction protocols.
- Examples of Call Double-Sided Auctions:
- Various business-to-business (B2B) Internet markets, day-ahead electricity
markets, ...
TYPE 4: ORGANIZED EXCHANGE MARKETS
Key Aspect of Organized Exchange Markets:
- Organized exchanges combine auction and OTC
market features in that they are centralized facilities managed in part
by "specialist traders" who combine broker and dealer functions
- Examples of Organized Exchanges:
- New York Stock Exchange EuroNext, electricity power
exchanges, real estate markets
Copyright © Leigh Tesfatsion. All rights reserved.