Wednesday, June 9, 2010

Schwartz, Micro Markets

Back when you took Econ 101 did you ever think about applying microeconomics to the markets? Probably not. And I would guess that even today most traders and investors are content to repeat the mantra that markets are driven by supply and demand even if they’re not quite sure how supply and demand actually work in the markets. Robert A. Schwartz in Micro Markets: A Market Structure Approach to Microeconomic Analysis (Wiley, 2010) has written a text that should bring everybody up to speed. Given some familiarity with microeconomics and the markets it’s not a difficult read, but it definitely fills some gaps.

Schwartz addresses several major themes: supply and demand (which not surprisingly takes up more than half the book), competition, market efficiency, and regulation. Here I’m going to confine myself to a few points that Schwartz makes about supply and demand.

Let’s assume a continuous electronic, order-driven market. How does the limit-order book function in such a market? “How do the forces of supply and demand guide the continuous order-driven market in the direction of an unobservable, underlying equilibrium price?” (p. 154) First, both limit and market orders are available to the trader, and “transactions are triggered by the arrival of market orders that execute against the posted limit orders.” (p. 155) Limit orders leave the book if there is a transaction or if they are cancelled for one reason or another. Limit orders can also be repriced—upward if sentiment turns positive, downward if it turns negative. In the former case the buy side of the book will start to fill in at higher prices; in the latter, the sell side will fill in at lower prices.

Bids and offers are made at discrete prices, so any graph of the limit-order book will look like ascending and descending staircases, almost meeting at the bid-ask spread. But we know that supply and demand are not graphed as discrete step functions; they are curves and, as such, are continuous linear functions. How, then, can we claim that they model the limit-order book?

Schwartz explains that “because trading is costly, not all potential investors participate in each trading session, and each individual order is only a partial representation of what an individual trader’s complete demand curve might look like. Consequently, on both sides of the market, much of the desire to trade is not expressed, it is just latent.” Expressed desires look like stairsteps; “the complete individual demand curves of everybody who is in the market” give us the Econ 101 graph.

Because not all buy and sell desires are expressed at any given moment we can’t identify a true equilibrium point. At best, we can say that “the natural market forces of demand and supply tend to push prices in the right direction (at least some of the time).” (p. 160)

One more point: the deeper the order book the flatter the cumulated buy and sell order curves. Or, put in the language of the markets and of microeconomics, the deeper the book the more liquid it is and the more elastic the buy and sell curves are.

Here I’ve offered only a glimpse into Micro Markets. It would make an excellent college text, but it also provides the perfect opportunity for the trader or investor to gain a new perspective on his world. And it won’t take you a semester to get through it.

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