How Prices Are Determined
A financial company called Admiral Financial Corporation (ADFK) trades for $.0001, or 1/10,000 of a penny per share. It has a little over 10,000,000 shares outstanding, which means you can buy the entire company for just over $1,000. Another financial company, Berkshire Hathaway (BRKA) trades for over $86,000 per share and has 1,272,000 shares outstanding. To buy this company would cost $109 billion dollars. Why the difference in prices? How do we decide on how much to charge for one share of stock? In other words, how are these prices determined?
As you continue to learn about the stock market, you will hear many different stories about the ways these prices come about and most of the answers are simply false - they are myths that have been spread from investor to investor over many years that eventually become accepted as truth. As often said, it is easier to believe a lie that one has heard a thousand times than to believe a fact that no one has heard before. Stock price formations, unfortunately, have fallen victim to this path. You will hear people say that stock prices are purely manipulated by the stock exchanges, whether those shares are traded through true auction markets such as the New York Stock Exchange, or electronic markets such as the Nasdaq. People continue to believe that these exchanges have complete control over what you pay but, as we will show later, these exchanges are better off not having that control. They are better off responding to the current bids and offers rather than trying to create them. It is crucial to understand the process otherwise your investment decisions will be clouded by the widespread false beliefs that continue to float across every conversation about the stock market.
So what - or who - does control stock prices? The answer is that all of us do. Prices are formed by our desire, or demand, for buying in relation to the supply that is available. If the demand for anything rises, the price will rise (assuming the supply stays the same). If the supply of anything rises, the price will fall (assuming demand stays the same). Changing the supply or demand affects price. Conversely, we can affect supply and demand by changing price. If we raise price, the supply will increase and the amount we want to buy will fall. If we lower price, the supply will fall and the amount we wish to buy will increase.
In economic terms, it is the supply and demand of stock that determines its price. Most of you have heard this answer before - it is the answer to every question that has ever been asked about price. But if you just accept "supply and demand" as the explanation, then it limits your understanding as well as your acceptance of the fact. So let's take a little closer look at what we mean when we say that supply and demand determine price.
Lemonade for Sale
Assume that you wish to run a lemonade stand. One of the decisions you must make is how much to supply, or make, over a given time period. Will you make one gallon or five gallons per day? This decision in itself is not easy. The amount you produce depends on how much you think you can sell. And the answer to that question depends on price, which is what we're trying to determine. The higher the price, the less you'll sell. The lower the price, the more you'll sell.
How much you decide to produce also depends on many factors including how much time and money you have available. For instance, you may be willing to make 50 gallons per day but do not have that much money available to buy the necessary ingredients. In addition, you'd also have to have a way to store it and haul it around if you do not sell your entire inventory. All of this requires time and money.
But let's just say that you are willing and able to take 100 glasses to the stand each day. You think you can sell them for $1 each; in other words, you'd be willing to operate the stand for $100 per day. This is the supply side of the equation and that's all you can control.
The Demand Side
Now let's look at the demand side. That's the side that the customers control. The price they are willing to pay for your lemonade does not depend on your cost. In fact, any buying decision for any product is completely independent of cost. For example, the amount of gas you buy each week depends on your needs and what you're willing to spend. If gas prices jump to $5 per gallon, economists are certain you'd buy less gas no matter what the reason for the price hike. You wouldn't buy the same amount of gas just because the store owner incurred a justifiable increase in cost. You don't care about their cost; you just know what you're willing to spend and for how much. Once you see the store owner's price, then you make your decision on how much to buy.
So while we have solid reasons for why you might be willing to supply a certain amount of lemonade at a give price, we really have no basis for determining how much people are willing to spend to get it. Value is based on personal tastes and is subjective. Some people may be willing to spend $5,000,000 on a Renoir painting even though the cost - the paint, canvas, and time - was likely to only be a few bucks. By the same reasoning, if I wish to sell thoroughbred horse stew, my costs would be enormous but I may not be able to sell any even if I sell below cost. People do not care what your costs are in determining the value to them so it's really tough to predict what value people will put on any product.
A recent example occurred in August 2004 right here in South Florida where a man called FEMA (Federal Emergency Management Agency) after Hurricane Charley nearly destroyed his mobile home. He received a check for $1.69. The agency claimed he didn't qualify for aid but sent him the check so that he could buy one gallon of gas for his generator since the electricity had been knocked out (by the way, gas was $1.83 at the time). The man was infuriated and he called a local radio station to criticize the agency. After some humorous conversations with the DJs along with comments from callers, the check started to take on a personality of its own. Eventually someone offered him $24 for the check! Now why would someone pay $24 for something that we can definitely say is only "worth" $1.69? The reason is that the check had more value, at least to that person, than the $1.69 intrinsic value. Maybe he wanted it as proof of the humor and irony of the situation. Or maybe it was to demonstrate the inefficiencies of government for a college course. We don't know why and it doesn't matter. All we know is that he was willing to pay dearly for that check, which would probably never be cashed. The value that people see in things is purely subjective; it is a value that exists in their heads.
Supply Meets Demand
You show up for your first day on the street with the lemonade stand. This is the first day where your supply is introduced to the customers' demands. But just before you hang the "open" sign on the front, you get an idea. Why charge only $1? After all, your friend told you about how the stock market is manipulated and that "they" put up outrageously high prices when you want you to buy and then "they" place ridiculously low bids when you want to sell. You realize you're now in control so why not learn from their little game and play along? You quickly change your price from $1 to $5 per glass.
But at the end of the day, you're a little dismayed. You didn't have a single sale and you're stuck with the entire inventory. It turns out that all the passersby had choices - and they chose to not patronize your stand.
The next day you reopen and decide to drop your price to $4 in hopes of getting people to try your stand. This time you get a couple of sales. The following day you drop your price to $3. You get a few more sales but are still stuck with the majority of the inventory.
Now you're really frustrated so you drop your price back to your original idea and charge $1. To your amazement, the tide has turned and people are flocking to the stand - but this time the problem is in the opposite direction. You have run out of supply and there are still people in line. Once they hear that you've run out, you've got mad customers on your hands and they may never return. So how can you strike a happy medium and sell 100 glasses without turning people away? The answer is to keep changing price until only 100 glasses are sold. Another way of saying this is that you want to charge a price where only 100 glasses are demanded; that is, you need to find a price where your supply equals demand.
When you charged $4 or higher, there was an excess supply and you ended up with unwanted inventory. With the price at $1, you ended up with excess demand and had extra people standing in line who were not able to buy. At some price between $1 and $4 then, you must be able to balance the two forces of supply and demand and that is the price where supply equals demand. That is the price that will leave you with no inventory as well as no remaining customers. That price is called the market clearing price.
Price acts to ration things. Like the gas and brake pedals of your car, price allows you to regulate the speed at which your products flow. If you raise the price, you can slow down the flow since people buy fewer things when prices are high. On the other hand, if you lower the price, you can increase the flow because people buy more when prices are low.
For example, when you charged $4 per glass, you had excess supply of lemonade. And when you charged only $1 per glass, you had excess demand and were forced to close up shop early. You did leave with $100 in your pocket but you also had extra customers in line who were willing to buy but were turned away. If you keep your price at $1 tomorrow, you will likely have the same outcome. However, if you charge more than $1, you will find that some of these customers will not want the product at that price and will get out of line. By raising price, you are tapping the brakes and your lemonade will not leave the stand so quickly now.
But what incentive do you have to change your price? The answer is that you will produce your maximum profit at the point where supply equals demand. And that's a powerful incentive. Let's assume that you find that by charging $1.50 that you sell exactly 100 glasses per day.
How do you know that $1.50 is the market clearing price and not some higher price such as $1.60? Assume you increase the price by 10 cents to $1.60. You are thinking that your revenues will now increase by $10 to $1.60 * 100 glasses = $160. However, once you announce the new higher price, you find that seven people back out of the line, which means your revenue at the end of the day is now $1.60 * 93 sales = $148.80, which is $1.20 less than the $150 revenue you had by charging the lower price of $1.50 per glass. The price increase did bring in an additional $0.10 for the 93 buyers, or $9.30. However, that additional revenue came at the expense of losing 7 people willing to pay $1.50, or $10.50. The net loss is $9.30 - $10.50 = $1.20, which is exactly how the amount of revenue you're missing. You quickly find that you're better off charging $1.50.
Why did seven people back out of the line? We're not sure. All we know
is that at the new higher price of $1.60, seven people felt there were better choices elsewhere and chose to not buy. Remember, the buyers' perception is the side of the puzzle that you cannot control. But by changing prices, you can control who gets what and the incentive you have to find this point is the self-serving interest of maximizing your revenues. And notice that in order to maximize revenues, you did not charge the highest price that people were willing to pay. We found out earlier that you did, in fact, have buyers at $4 and even more sales at $3 but you have settled on a price of $1.50. Even though you had complete control to "charge whatever you want," you have chosen to settle on a relatively small amount. You have chosen the market clearing price of $1.50, which is what any profitable business owner would have figured out to do.
Hopefully this has convinced you that deliberately raising prices above their market clearing price is not advantageous to the business owner. But the economic myth persists in many in nearly every topic about prices. For example, people firmly believe that the reason movie theaters charge so much for popcorn is because "they have you captive" once you enter the gates. If that's true, why not charge twice as much for popcorn? Why not charge another price for the bag? People also believe that monopolies can exercise great pricing powers but, upon some thought, you will find they're really not that much different from other types of businesses. If they were, your utility company would charge thousands of dollars, perhaps millions, per month. Why do think they settle on a relatively minor amount? The answer is that movie theaters and utility companies must act within the constraints of consumer demand. They must price within what we are willing to pay because, just like we found with the lemonade stand, people do have choices. And even though there would certainly be people willing to pay the higher prices, movie theaters and utility companies choose not to because they earn more money by clearing the market.
If you understand this simple example of how markets clear, then you are ready to find out how stock market prices are determined.
The Stock Market
Stock prices are formed very much like the lemonade stand example with one big difference. With the lemonade stand, you knew how much product you were willing to supply but did not know how much of it would be demanded at that price. With the stock market, we know at all times how many people are willing to buy and sell and at what prices. And that makes it very easy to find the optimal price.
Let's look at the stock market business by assuming you are now the market maker for ABC stock. The market maker is the person who stands between all buyers and sellers to ensure an orderly market. If, for some reason, there are no buyers or sellers then the market maker will step in to provide liquidity.
It is your first day on the job and you need to determine the opening price of ABC stock. Unlike the lemonade stand, you are not bringing the supply to market - other stock traders are. But in a similar way, it is still your job to balance the two forces of supply and demand. To make the example easy, we're going to assume that there are 11 people who want to buy ABC stock and 11 who wish to sell and they all wish to trade 100 shares.
The market hasn't opened yet, but you are already receiving orders. Let's say you receive an order to buy 100 shares for $20. In market terms, we would say this person is bidding $20 for 100 shares. Buyers submit bids. This means the person is willing to buy 100 shares for no more than $20. The order does not need to be filled for exactly $20. If you can fill the order for less money, the trader will presumably be happy. Another trader sends in an order to buy 100 shares at $19.50, which means he is willing to pay up to $19.50 for the 100 shares; he will certainly be happy to pay less. We'll assume that nine other buyers send in orders to their brokers with each order decreasing in price by 50 cents.
At the same time, sellers are sending in orders too. Assume that one trader sends an order to sell 100 shares for $15. In market terms, we would say this person is submitting an offer or is asking $15. This means that the trader will sell for no less than $15; he will certainly accept more. Another trader sends an order to sell 100 shares for $15.50, which means he will accept no less than $15.50 for his sale. Nine other traders place sell orders too with each one increasing their price by 50 cents.
Your computer program organizes all of these trades from the highest bidder (buyer) to the lowest offer (seller), which are summarized in Table 1 below:
Table 1: Buyer and Sellers of ABC Stock
Based on the information in Table 1, which price should you charge for ABC stock at the opening bell? You know that someone is willing to spend $20 for the stock as demonstrated by the highest bidder so why not exercise your power and set the price at $20? Won't that maximize your profits? But this sounds familiar and you are having flashbacks of running the lemonade stand. You quickly remember that charging $5 - even though you were allowed to - was not the optimal price. Maybe you should check the numbers to see how this will turn out.
If you charge $20, you could match the top bidder (#1) with any of the eleven sellers (all of them are willing to sell for $20 or less) and you will only sell 100 shares for $20 and generate $2,000 revenue. Why will only 100 shares be sold? Even though there are eleven traders willing to sell for $20 or less, there is only one buyer so only one trade of 100 shares can be completed.
What will happen if you lower your price to $19.50? At this price, you could match buyers #1 and #2 with any of the sellers #1 through #10 , which generates 200 shares * $19.50 = $3,900.
At a price of $19, you can match buyers 1 through 3 with any of the sellers #1 through #9. This generates 300 shares * $19 = $5,700. Note that each time you lower price, the number of buyers increase while the number of sellers decrease. Table 2 summarizes all the possibilities:
You can see that your maximum revenue is generated at a price of $17.50. At that price, your revenue is $10,500 and no other price combination can get you a higher amount (that's true even if we were to try price increments other than 50 cents). It's also true that $17.50 creates the highest number of trades (600 in this example). The maximum profit is therefore a balancing act between price and volume. Lower prices may sound bad at first but you have to consider the additional sales, or trades, that it will generate. At some point, it will not pay to lower prices anymore since the additional trades do not cover the loss in price.
So one way we can find the optimal price for this opening stock price is by trial and error. We can try different prices and see what the revenue outcomes will be and then pick the combination that nets the highest return. However, there is an easier way for us with the stock market. We can simply look at the price where the number of buyers equals the number of sellers and that is our market clearing price. Remember, you have that power to do that here since you can see what the bidders are willing to pay (the demand side) as well as what prices traders are willing to sell for (the supply side) as shown by the offer prices in Table 1. You didn't have that luxury with the lemonade stand and had to find the optimal price by trial and error.
Let's see how it works and how simple it really is. At a price of $20, you have one buyer (#1) but eleven sellers. Everybody is willing to sell at a price of $20 or lower. At $20, there is a mismatch between the number of buyers and sellers. Specifically, there are too few buyers in comparison to the sellers. In order to evenly match them, we must hit the gas pedal to accelerate the buyers. And we do that by lowering price.
At $19.50 you have two buyers (#1 and #2) but have ten sellers (#1 through #10). Our lower price is working since we have increased the number of buyers and decreased the number of sellers but we're still not balanced yet.
At $19, there are three buyers and nine sellers. We're moving in the right direction but still not there yet. As you move through the list of prices, eventually you'd find that at a price of $17.50, there are six buyers and six sellers and that must be our optimal price. In the real world of stock trading, computers do these calculations instantly. Depending on the orders that are arriving, they will find the clearing price of the stock and that is the price that you see quoted.
Picture Your Profits
We can find the same answer by graphing the list of bid and offer prices in Table 1. If you do, you'll get the following chart:
You can see that the two lines - supply and demand - cross at $17.50
and at a quantity of 600 shares.
That is the point where supply meets demand and the market is cleared.
When you first look at Table 1, it's easy to think that all traders are influencing the final price of the
stock. But the truth is that it's only buyers and sellers # 6 that are the ones determining the final price. If their prices had been a little different - even by one cent - we would have a different clearing price. While the highest bidder was willing to pay $20 and the lowest offer was $15. Their prices, ironically, have no bearing on the final price. If these prices were instead $30 and $10 respectively, you'd still find that the clearing price is $17.50. Because of this, we say that it is the marginal traders - the ones on the edge of the current price - that are solely responsible in determining a stock's price. The final quoted price has nothing to do with the highest bidder or lowest offer. And it definitely has nothing to do with the market maker. The market maker simply finds the optimal price based on the orders received. It is the marginal traders who determine the price of a stock. If you don't believe it, you can do a little test the next time you submit an order. For example, assume a stock is bidding $29.90 and asking $30. If you place a limit order to buy above the current asking price, you'll find that you'll be filled at the current asking price (or at least very close). If you place an order to buy 100 shares for $40, you'll find that the order is filled for the $30 asking price and not for $40 (be careful in after-hours trading though, it would be filled at $40 since it is not a live auction!) Why won't the bid jump to $40 since you're now the highest bidder? That's because your order has no bearing on the price of the stock; your order is outside the marginal prices. In fact, many traders will tell you the quote represents the highest bidder and lowest offer but that's not quite right. It really represents the highest bidder and lowest offer at the margin. If the quote represented the true highest bidder and offer, then the quote would be bid $40 and asking $30. The same is true for the sell side. If you place an order to sell for $20, you'll be filled for the current bid of $29.90 (or very close). It is the marginal traders who determine price. And when you look at a stock quote, you're really looking at the highest bidder and lowest offer at the margin.
Thoughts about Price
The price of anything you buy is determined in a similar manner as the way we found the optimal stock price. It is the price that equalizes buyers and sellers. Whether you buy a gallon of milk or a gallon of gas, prices will vary depending on the supply and demand at that time. If there is a sudden surge in demand, we can apply the brake by increasing prices and reducing the flow. If there is a sudden increase in supply, we can press the gas pedal by lowering price and increasing the flow.
If there is ever an imbalance between supply and demand then one of two conditions will occur: You will either find that the supplier is out of product (price is too low) or that the supplier has excess product to sell (price is too high). Obviously, it is difficult for most retailers to exactly match buyers and sellers as peoples' tastes and preferences change constantly. That's why stores occasionally run out of items or have to run clearance sales to encourage buying and clear the shelves of unwanted inventory. But for the most part, everybody who wants the good at that price should be able to get it; otherwise someone is not properly setting prices.
As an example, the Citrix Open Tennis Tournament is held every year
here in Delray Beach. Last year, the grandstand for the final was probably
30% filled. That's an obvious sign that prices are too high. Despite the
advertising efforts, the tournament was willing to supply far more seats
than what people wanted at that price.
Lowering the price would have filled the seats - and increased their revenue as well.
On the flip side, during hurricane Frances, our shelves were cleared of food, drinking water, batteries, and other essentials. Gas stations had enormous lines and all eventually ran out of gas. Those are signs that prices are too low. Why don't stores increase prices to adjust for the increase in demand? They would except for the fact that the government imposes "price gouging" rules, which are mistakenly intended to keep the retailers from "taking advantage" of the consumers during times of emergency. The prices stores charge for a product must not exceed the average price for the preceding 30 days otherwise they can be charged with price gouging. Artificially keeping low prices during a surge in demand is the recipe for an immediate mismatch in supply and demand. You have far more buyers (demand) than goods available for sale (supply) and the shelves will be swept clean.
So who cares that the stores are sold out? Should retailers be allowed
to profit by charging higher prices and keeping more products on the shelf? The answer to that is easy once you understand marginal values. When you decide to buy anything, the question is not "how much should I buy" but rather "how much should I buy at this price." For example, if water is expensive, say $100 per gallon, you would probably only buy what you need to survive. But as the price gets cheaper, you will find other uses. Say the price falls significantly so you decide to buy some more in order to take showers. The additional use of showers is called the marginal use of water since that is the newly added use to the list. It is the marginal value that determines price just as the marginal traders determine stock prices. As the price continues to fall, you may decide to water plants, wash the car and, finally, wash the dog. Every time price falls, new uses are added. Fortunately, water is so plentiful that the marginal value is pretty low. That's why we'll use it to wash windows or start a fish aquarium.
But during a hurricane, the marginal use of water rises. Everybody knows that supplies are tight and we should be stocking up on water for drinking; that is, to stay alive. If we're buying water for the marginal use of staying alive then its price should be high. But when the government tells the store owner they cannot raise prices, then people will buy water for other uses whose marginal values are much lower. People will stock up on water to cook, clean dishes, wash their hands, water plants, wash the dog, and fill the windshield wiper reservoir in their cars. As a result, others are left without water to drink. Governments sometimes attempt to keep product on the shelves by running public advertisements to "buy only what you need" but those ads tell us what we already know. Remember, people always "buy what they need" but that is based on the current price. And if the current price allows it, they will buy for all sorts of needs that are probably not deemed to be "necessary" by most people during a pending natural disaster.
Batteries are another example. During a hurricane, everybody should have some batteries to listen to a radio for emergency alerts or to run a flashlight if the electricity goes out. But when you get to the store, it is not uncommon to see people in line with 20 packs of batteries. The reason is that, at the artificially low price, people are certainly buying them for radios and emergency lighting but also to run electronic games, television, DVDs, CDs, and other forms of entertainment. Because the stores cannot raise prices, these people will be fully entertained during the hurricane while many are left in the dark.
The Market Never runs out of Stock
If prices were allowed to adjust, the stores would always have water and batteries available for everybody. Sure, they would be expensive, but at least you'd have water to drink at the expense of someone's dog not getting washed. And you'd have a flashlight to get around in the dark because the higher battery prices will force someone to go without GameBoy. The price gouging laws actually hurt consumers despite their sympathetic intention. Stock prices are allowed to change and they do - rapidly. Prices plunged upon hearing the news of the September 11 attacks. And in early 2000, the biomedical company Entremed (ENMD) spiked from $30 to $70 in two days. (Why isn't this considered price gouging?) These price swings are not due to the exchanges taking advantage of critical situations but rather to make sure that all buyers can be matched with all sellers at that price. It is the most efficient way to run a market. Because prices are allowed to change, the stock market never runs out of stock. We cannot say the same about store inventory during hurricanes.
So when you hear someone blame the market makers because the price jumped just before they bought the stock or that the price fell the second they placed their sell order, you'll hopefully now understand that it is a misperception. The market maker is better off finding the price that clears all buyers and sellers and not in finding the highest price that someone is willing to pay or the lowest price for which someone is willing to sell. While erratic price changes may appear to be price manipulation, it is simply the result of the marginal traders trying to do the same thing as you. If you think it is a good time to buy or sell, chances are that others do too and that's why the price moves are usually adverse - everybody's trying to do the same thing at the same time.
As you get involved with stock trading, don't spend your time trying to
"beat the market makers." They are not the ones to beat; they are there to match buyers and sellers. Instead, try to figure out how news and events will affect the supply and demand for your stock and use that knowledge to trade with. If you do, you will be happy to see the market makers doing their job to clear the markets - and you will profit in return.