Price Formation in Double Auctions

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Price Formation in Double Auctions

Published Date

1995-11

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Center for Economic Research, Department of Economics, University of Minnesota

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Working Paper

Abstract

Markets have the capacity to resolve complex coordination problems. Hayek [1945] asked how privately held market information is organized through the trading process to arrive at competitive equilibrium. We propose strategies for sellers and buyers in a double auction (DA) market that result in transaction prices at or near competitive equilibrium in a variety of market environments. A large experimental literature documents convergence in many market environments to competitive equilibrium, but the theoretical literature treating the bargaining behavior in this institution is relatively small, and the models presented to date do not account for the many regularities observed in the data from experiments. We provide a model that accounts for several important regularities of double auction data. We model an informationally decentralized decision making procedure for sellers and buyers. Sellers form beliefs that an ask will be taken by some buyer. Similarly, buyers form beliefs that a bid will be taken by a seller. These beliefs are formed on the basis of observed market data, including frequencies of asks, bids, accepted asks, and accepted bids. Then traders choose an action that maximizes their own expected surplus. While traders in this model form beliefs about the probability that a given action they choose will result in a transaction, they have no beliefs about the types (costs or valuations) or strategies of other traders. The trading activity resulting from these beliefs is sufficient to achieve transaction prices near competitive equilibrium and complete market efficiency after several periods of trading.

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Previously Published Citation

Gjerstad, S. and Dickhaut, J., (1995), "Price Formation in Double Auctions", Discussion Paper No. 284, Center for Economic Research, Department of Economics, University of Minnesota.

Suggested citation

Gjerstad, Steven; Dickhaut, John. (1995). Price Formation in Double Auctions. Retrieved from the University Digital Conservancy, https://hdl.handle.net/11299/55740.

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