with Price-Setting Agents
- Last Updated: 28 March 2015
- Professor of Econ, Math, and ECpE
- Department of Economics
- Iowa State University
- Ames, Iowa 50011-1070
tesfatsi AT iastate.edu
Home Page for EE/Econ 458
A. What is Market Organization?
In modern usage, a commodity is anything of use that can by bought or sold in standardized form.
A market is any context in which the buying and selling of a commodity 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
- 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 commodity Q (for example, housing, or stock shares) by matching asks for Q (offers to sell) with bids for Q (offers to buy).
- 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 for Q| |Payment for Q
Bid | BROKER | Ask
(Buy Offer) | |(Sell Offer)
Units of Q | (Passed Thru) | Units of Q
Key defining aspects of a DEALER:
- Unlike brokers, dealers take positions in the commodity Q in which they trade (i.e., they own inventories of Q).
- 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
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 of Bilateral Trades:
A power purchase agreement (PPA) between a buyer and seller of electric energy; a loan you arrange with a family member; the self-sale of a home, the self-sale of a used car.
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:
- Markets for corporate bonds; markets for U.S. Treasury bonds and notes; the NASDAQ stock market; used car dealerships; the Foreign Exchange Market
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/or asks are all posted at one time, or continuous markets (e.g. stock exchanges, real estate markets) for which bids and/or 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, one or more SELLERS publicly post their asks (offers to sell) in advance.
- If the auction is a BUYER posted-offer auction, one or more 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
- 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 (offers to sell) to the centralized facility.
- Buyers submit bids (offers to buy) to the centralized facility.
- The centralized facility matches these asks and bids in accordance with the auction protocols.
- Examples of Call Double Auctions:
- Day-ahead energy markets, various business-to-business (B2B) Internet markets
TYPE 4: ORGANIZED EXCHANGE MARKETS
Key Aspect of Organized Exchange Markets:
- Organized exchanges combine auction and OTC market features. They are centralized facilities managed in part by specialist traders who combine broker and dealer functions. For example, stock trades in the NYSE-EuroNext are managed by specialists who typically act as brokers (matching buy orders with sell orders) but who sometimes also act as dealers (buying and selling on their own account) in order to facilitate trades.
- Examples of Organized Exchanges:
- Electric power market exchanges, New York Stock Exchange (NYSE) EuroNext, real estate markets
Copyright © 2011 by Leigh Tesfatsion. All rights reserved.