Chap 8 - Price Discovery

Meaning of Price Discovery

Classifying Price Discovery Mechanisms

Different Price Discovery Mechanisms

RIP - MF Global Holdings (Oct 31, 2011)Sales $2.3 Billion Assets $50 Billion

Liabilities $44.5 Billion Liabilities-to-Equity Ratio 32:1

Earnings - $76.7 Million

Filed for Chapter 11 bankruptcy - bad bets on European debt

“Extensive Riskitis” - could not be saved

Price Discovery Process -Mechanism - Institution

arrange acceptable terms of trade for transfers of ownershiptrue willingness to pay/accept payment

Diversity - systems used

across commodities: house, food, powerAcross locationsOver time

Costs & Benefits

Every transfer involves costs – cost of price discovery

Different mechanisms => different investments of time & resources

Factors Affecting Number of Changes

in Ownership

Economies of scale

Greater control – quality, quantity & timeliness

Cost of arranging transfers of ownership (TC’s)

Consequence:Less trade through spot (terminal) marketsAlternative mechanisms

Agricultural industrializationmore contractingcontinuing ownership of products through successive stages of marketing

More marketing services => + changes in ownership

March 12, 2001 – Headline - Feedstuffs

due to declining volumes,the cash (spot) market for hogs in the US will be non-existent within 5 years

what mechanisms will be used to establish (discover) the price of hogs?

prices in cash market are signals to market participants

efficiency = f(extent to which prices give correct signals)

System of price discovery must be robust to:

mis-representation of preferences, small or unequal numbers of buyers and sellers, andcoalitions of buyers and sellers

Price Discovery Mechanisms

Individual Agreements – peer to peer, private

Group Actions – public arena – groups of agents

Government Influences - interventions

Individual AgreementsDistinguishing Different Types of Transactions

1 - When does exchange of ownership occur?Immediate or in the future?

Forward contracts (marketing/production contracts) vertical co-ordination

reduce price risk faced by buyer and sellerassurance of quality characteristics for buyer (quality risk)

Alternative to contracting - vertical integration

replaces transfers with an alternative set of contracts within the firm

Common in chicken, eggs, turkey

US Hog Production and Slaughter

Hogs on farms with more than 2,000 head

38 % in 1994

79 % in 2004

Source: Martinez, Steve. The U.S. Food Marketing System: Recent Developments, 1997-2006.ERS, Economic Research Report, Number 42: Washington, May 2007

C4 hog slaughter - increased 20% over 10 years, to 64% in 2004

C4 cattle slaughter - 70% (2004)

Marketing Contracts:1993 87% of hogs sold on spot market

200670% of hogs sold using contracts20% owned and slaughtered by the packer10% sold via “negotiated purchase” (spot market)

Source: MacDonald, J.M. and Penni Korb. Agricultural Contracting Update: Contracts in 2008. ERS-USDA, Bulletin Number 72, February 2011

Source: MacDonald, J.M. and Penni Korb. Agricultural Contracting Update: Contracts in 2008. ERS-USDA, Bulletin Number 72, February 2011

Source: MacDonald, J.M. and Penni Korb. Agricultural Contracting Update: Contracts in 2008. ERS-USDA, Bulletin Number 72, February 2011

Contract Broiler ProductionHigh level of vertical co-ordination – “integrator” & farmers

Integrator:

Breeding flocks, hatcheries, feed mills, processing plantsProvides chicks, feed, medications, technical advise, managerial oversightResponsible for processing & marketing

Farmer: housing (25,000 sqft per house; 50,000 birds), litter, labour

Increased efficiency, uniform birdsReduced land & capital requirement vs full integration

Reduced capital & expertise requiredReduced marketing riskLow return to labour in early years

Price – “negotiated” – with premium + discountsFew integrators

Individual AgreementsDistinguishing Different Types of Transactions

2 - How is price negotiated ? Pricing Arrangements

Explicit (Posted) Price OR Negotiated Price?

When it is worthwhile for agents to bargain/negotiate ?

potential gain through good negotiating skillsvalue of the sale is relatively largeability to price discriminateBenefit > transaction cost

Individual AgreementsDistinguishing Different Types of Transactions

Price for future delivery: Deferred pricing according to a formula?

Predetermined price - Price & quality risk

-feel cheated - - potential for default – transaction cost

Alternative – Predetermined mechanism for price

Link price to some “anchor price” – e.g. Basis ContractPremiums/discounts - quality variations

Price determined outside public markets – information loss

Group Actions Auctions

competitive - revelation of valuation (livestock, EBay)

more or less public

location - electronic auctions and efficiency

single or multiple items simultaneously

Vernon Smith (2002) auctions and economic experiments

Auction structures – strategies + price (valuation WTP)

English (open outcry) DutchFirst price Second price (Vickrey)Double auctions (CBOT)

WTP ≥ English = Second price > First > Dutch

Group Bargaining

Multiple agents cooperate

countervailing power (marketing boards/co-ops)willingness to finance costsrequires group solidarity – no “free riding”

CWB – “public goods”

Government Intervention Enabling legislationPhysical facilities Information (USDA/Agr-Can)

Direct Interventionminimum or maximum pricesregulated industry groups

Price discovery – many alternative institutions

Choice – Benefits/Costs (Transactions costs)

Dynamic