What causes the fluctuation of stock prices? Most people will assume that supply and demand cause stock prices to rise and fall, but they would be, to a degree, incorrect. It’s a tricky concept to grasp, but price discovery is what causes stocks to rise and fall.
This concept is too often compared to supply and demand. Although similar, they are not the same. So, what exactly is price discovery and why is it so crucial to markets? Let’s get started with the price discovery mechanism right away, shall we? Although price discovery is often discussed in the context of financial markets, it is the process of determining the price of a commodity in the marketplace through the interaction of buyers and sellers.
This mechanism works in any situation, whether you’re buying a car, or bidding up a product on a yard sale. The price discovery mechanism is affected by a variety of factors. Some of these elements include: the total number of buyers and sellers, the willingness or risk appetite of the buyers/sellers, and the transaction costs.
Let’s take a look at a simple example:
If there are many more buyers than sellers, sellers will have more power to set the price they want, for the product they’re selling, causing the price to rise. Similarly, where there are more sellers, buyers will have more options and will be able to get a better offer.
However, the seller’s willingness to lower the price they are asking could play a role. If the seller refuses to lower the price, the transaction may not go ahead. As a consequence, willingness plays an important role, just as much as if the transaction cost is too high. This discourages transactions and limits price discovery.
Let’s look at some more examples to better understand how prices are determined. Imagine there’s only one of Tesla’s Semi trucks for sale, but there are a lot of buyers. One person wants to buy it for $180,000, another offers $190,000, and yet another offers to buy for $200,000. Assuming the seller is asking for at least $180,000, the buyer who can and will pay the highest amount, which is $200,000, is the one who gets the Semi, and therefore the price discovery process culminates with the highest bidder.
However, if the seller wants to get at least $250 000, he won’t consider any of these deals, therefore there will be no sale and no price discovery. The truck won’t be sold until a buyer comes in to buy it for $250,000 or the seller drops their asking price to match a buyer with a lower bid. In this situation, the seller wields absolute control, and he, along with the marginal buyer, is responsible for the price discovery.
What happens if the scenario is reversed, with just one buyer and several similar trucks? The buyer who can purchase any of these trucks has the best position. Furthermore, imagine three trucks, all of which are priced the same at $200,000. But if the buyer is only willing to pay up to $185,000, none of these three trucks will sell.
But if one of the sellers lowers their asking price to $185,000 or less, the buyer will now step in and buy the truck. In this case, the buyer wields near absolute control. One important point to remember is that, despite the fact that all of the trucks are identical, all of the sellers do not have to lower their price. All it takes is one seller to lower the price, also known as the marginal seller, to facilitate the price discovery. After this transaction occurs, the other two trucks are effectively valued at $180,000 each, not $190,000 nor $200,000.
- The process of determining the price of a given asset or commodity is known as price discovery.
- A marketplace’s primary role is price discovery.
- It is determined by a number of tangible and intangible variables, including market dynamics, liquidity, and flow of information.
As we can see in the above-mentioned cases, the transaction occurs when the marginal buyer and seller transact and set the prices. To summarize, price discovery is the process through which prices are determined by the interaction between buyers and sellers. We used the auto market as a case study, but it works in every transaction.
Whether you’re buying groceries from the farmers market or the grocery store, the price is discovered by the sellers, who are the farmer or the grocery store, and the buyers, who are willing to buy the commodity – thus creating a dynamic price setting and efficient market activity. This same price discovery process happens in the Forex and Stock markets where you can participate through an account with Tradeview Markets.