How is the Opening Stock Price Determined?
You may have noticed that the opening price of a stock is not necessarily the same as the previous day's closing price just as we saw with the earlier Entremed example. In fact, stock prices open more often than not at a slightly different price. We can extend the desert problem above to include costs to the seller as well and explain why stocks vary between closing and opening prices.
Just as our desert tourists were bounded by perceived values, sellers are bound by costs. As long as the benefits outweigh the costs, sellers are willing to sell at that price. Note that this does not mean that sellers will not sell for losses. If you buy stock for $50 per share and it is now trading for $45, you may certainly be willing to sell it if you think it will collapse to $20. The benefit of selling it at a $5 loss certainly outweighs the perceived cost of holding it. Seen in this way, costs too can be an opportunity cost perceived by sellers; it does not necessarily have to be the amount paid to buy the goods.
The reason that stock prices vary between closing and the next day's opening is because news is always circulating around the clock whether the stock exchanges are open or not. Based on the news, investors and speculators will place orders with their brokers prior to the opening of the stock market. Because the stock is not trading at that time, the market maker (or specialist on listed exchanges) ends up with a list of buy and sell orders and must determine a fair price for the opening. What is a fair price? It is the equilibrium price; the price that clears the market. You can be sure the market maker will find the equilibrium price for the same reason you did when selling water. It’s the price that maximizes their revenue. Suppose one day before trading, a Nasdaq market maker has the following orders shown in Table 4:
Table 4:
The orders are separated into "buys" (also called bids) on the left and "sells" (also called offers) on the right. The orders are listed in order of the highest bidder first and the lowest offer first. This is because, for any trade, the market is most concerned with who will pay the most and who will sell for the least. After all, if a stock is trading for $50, for example, we shouldn't be concerned with the buyer who is willing to pay $1 or the one willing to sell for $100. We want to know who will pay the most and who is willing to sell for the least and those are precisely the trades showing in the top row.
The highest bidder has an order to buy 100 shares at a limit of $20. A buy limit order means that is the highest price the trader is willing to pay. Therefore, this order is eligible to be filled for any price up to and including $20 per share. But if the stock opens at $20.01 or higher, the order will not be filled. The second highest bidder has a limit order in to pay $19.75 for 300 shares, and so on.
Similarly, the lowest offer is a sell order for 300 shares at a limit of $16.50. A sell limit order means that it is the lowest price the trader is willing to receive. This order is eligible to be filled for any price at $16.50 or higher. The next lowest offer is for 200 shares at a limit of $16.75 and so forth.
The "cumulative" columns just show the total amount of purchases and sales that would occur at the posted limit price. For example, if the market maker opens the stock at a price of $19.50 there will be 700 buy orders ready for execution. The reason is the first trader under the “Buys (Bids)” column is willing to pay $20 for 100 shares. If the stock price opens at $19.50, his order is certainly due to be filled.
The next trader on the list is willing to pay $19.75 for 200 shares so, for the same reason, would be filled for $19.50. Finally, the third trader in that column is willing to buy 400 shares at $19.50 so would be filled for the same opening price. Therefore, at an opening price of $19.50, the first three orders are due to be filled and they total 700 shares (100 200 400). All remaining buyers are willing to pay less than $19.50 so would not have their orders filled for that opening price. That’s why the number 700 shows at a price of $19.50.
A similar reasoning is used for the “Sells (Offer)” column. The only exception is that higher opening stock prices create more sellers (law of supply). Other than that, the meaning of both “cumulative” columns is the same. They both show the total number of shares to be purchased or sold for any given opening stock price.
Assume these ten buy and ten sell orders are the only ones received before the opening of the market. At what price will the stock open for trading? We know that the market maker, acting in his self-interest, will maximize profits if he finds the equilibrium price. That is, he must find the magical price that exactly balances buyers and sellers. That price, whatever it turns out to be, will be the point where the quantity supplied (sellers) equals the quantity demanded (the buyers).
Naturally, market makers have computer programs that calculate these levels, as there may be thousands of orders. However, to really understand how a stock’s opening price is determined, let’s step through this one by hand, which will be easy since there are only ten buy and sell orders. Looking at Table 4, of all the infinitely possible stock prices you could choose to open with, which would it be?
You might be tempted to open the stock at $20 to capture that high bidder. However, this would be the same mistake as trying to sell your water in the desert to the highest bidder of $11. Recall that in that example we found that choosing a price that equals the highest that one person is willing to pay may not be your best choice, despite the intuitive appeal.
In this example, if the market maker opens the stock at a price of $20, there will be one buyer for 100 shares and 2,200 shares available for sale, so this is clearly not the optimal price and another price should be chosen. Should the market maker increase or decrease price to find the optimal solution? At a price of $20, we just found there are more sellers than buyers so the laws of supply and demand tell us the price is too high. Too high of a price means there will be a lot of sellers and few buyers and that’s exactly what we are faced with here. The market maker should choose a lower price.
If he lowers price, he will bring in some new buyers (law of demand) and also reduce the number of sellers (law of supply). How about an opening price of $18 then? If the stock opens at $18, there will be buyers for 2,500 shares and sellers for 1,600 shares. Now we have the reverse problem with more shares willing to be purchased than shares offered for sale. The price needs to be raised. At $18.25, there are 2,200 buyers and 1,900 sellers. We're getting closer, but the price still needs to be raised. However, at $18.50, we reverse again and have 1,600 buyers and 2,000 sellers so the price is too high.
So $18.25 is too low and $18.50 is too high and we cannot split between these prices anymore with any benefit. In other words, setting a price of $18.40, for example, will not bring equilibrium any closer. But there is one thing we can do since financial markets operate with two prices – a bid and ask. As a market maker, he can bid $18 and ask $18.50. In doing so, he will purchase 1,600 shares from all sellers who are willing to sell for $18 or below.
With an asking price of $18.50, he will sell to the 1,600 traders willing to buy at that price or higher. With an opening quote of bid $18 and asking $18.50, the stock is off and running for trading with volume of 3,200 shares. (The Nasdaq counts buys and sells separately and would count this volume as 3,200 shares since there are 1,600 purchases plus 1,600 sales. Exchanges, such as the New York Stock Exchange (NYSE), only count one side of the trade and would show a volume of 1,600. This is why volume on the New York appears dwarfed by the Nasdaq.)
At a bid of $18 and asking price of $18.50, the market maker’s profits are maximized, and every buyer willing to buy for $18.50 and every seller willing to receive $18 are able to do so. They market is cleared. The most important thing to see from this example is that it is the market that determines the opening price of the stock. It is the net effect of the entire list of buy and sell orders. It is not, as many people believe, the result of the market maker “jacking up” the price because he can get away with it. The market maker always has the incentive to find the price that is most fair for all buyers and sellers – the market clearing price. That’s the same price that maximizes his profits so we can be assured that his self-serving interests will result in doing what’s best for everyone. If only supermarkets were allowed to do the same in Florida.
The concepts of supply and demand provide significant insights for the art and science sides of economics. For example, should we recycle paper to increase the number of trees? Although recycling is regarded as a desirable quality for the community, let’s see what the “dismal science” has to say by considering supply and demand.
Save the Trees
The law of supply is a powerful force (after all, that's why it's called a law) but unfortunately, the simplicity behind it is often forgotten in many popular opinions, such as paper recycling. Environmentalists firmly believe the number of trees will increase if reduce the rate at which we’re chopping them down to make paper. After all, how can one argue with the logic that we will have more trees if we cut fewer down?
The law of supply even works for recycling and why economists are so against paper recycling as a means for saving trees. Paper is made from trees and if you use more paper, you are implicitly demanding more trees and will drive up the price of paper (and trees) in the process. Tree growing companies, such as Georgia Pacific, will respond and gladly grow more trees at the higher prices. Georgia Pacific is no different from any other company that uses resources (in this case, land) to generate profits. The higher the price, the more products they will supply.
However, if you recycle paper, you are decreasing your demand for trees and are lowering the perceived value of trees. If tree prices fall far enough, condominium developers may become the highest bidders and Georgia Pacific will respond and gladly supply their land to them for a higher yield compared to what they will earn if they use the land to grow trees. In fact, Resources for the Future, an economic "think tank," has estimated that the tree population will decrease by about 7% at the current rate of recycling. Price regulates everything and even the sympathetic attempt of recyclers to save trees cannot escape economic forces.
The mistake people make when arguing in favor of paper recycling is implicitly believing that trees come for free. If paper manufacturers could freely cut down trees growing anywhere, then environmentalists would have a valid argument. However, that's not the case. Paper manufacturers must pay for those trees and if the price of those trees falls low enough, trees will be exchanged for condos. This is why property rights are so important to the U.S. economy. As long as companies like Georgia Pacific are allowed to own the land and grow trees for profit, your demand for their trees determines how many they will grow.
If nobody owns the resources, then restrictions, recycling, or conservation efforts may be in order.
For instance, nobody owns the fish in the sea so it is a resource that can be depleted. If nobody owns the resource, then nobody can set a price. If there is no price, there is probably more demand than supply and it’s only a matter of time before the supply runs out. This is why the government regulates fishing activities by requiring licenses and restricting the number you can catch. It is an alternative way to regulate the natural supply of fish with the demand.
We’ve taken a brief tour of the concepts of supply and demand along with various applications. These economic foundations are critical to understand once we start talking about how interest rates are controlled. The most important facts to understand are:
Supply and demand together determine price.
As price is raised, sellers produce more (law of supply).
As price is lowered, consumers buy more (law of demand).
At price equilibrium, the market is cleared. All buyers willing to pay that price will be able to purchase the goods or services.
If price is not in equilibrium, either shortages or surpluses appear. If the price is too high, there will be more sellers than buyers. If the price is too low, there will be more buyers than sellers.
Supply and demand are really two sides of the same coin and price changes affect both consumer and producer. They are often compared to two blades on a pair of scissors. It’s not one blade or the other that does the cutting; it’s both. Likewise, it is both supply and demand that determine price and not one or the other.
A change in demand affects price and will therefore affect the amount supplied. Likewise, a change is supply will affect price and will affect the amount demanded. This is why it is essential to consider both forces and not just one or the other for any type of price analysis. While this may now seem obvious after reading this section, the obvious is easy to forget.
As a case in point, shortly after the September 11 terrorist attacks on New York City, many news articles were circulating predicting that the prices of airline flights would plummet. They reasoned that people would be terrified to fly and it’s obvious that if demand falls then price must eventually fall too. But notice this analysis only focuses only on one side – the demand side – of the problem. Nothing was ever considered about the other side – the supply side – of airline seats. If passengers are terrified to fly, the pilots and flight attendants are probably not too eager to take off for the not-so-friendly skies either. Perhaps we should assume that airlines will reduce the number of flights and we need to take that into account before predicting what will happen to price.
And that’s exactly what happened. The airlines realized that demand would drastically fall (or realized they didn’t want to supply flights with such high risk) so also cut the number of routes in response to the news – they cut the supply. In fact, they cut the supply of flights far more than the drop in demand with the result being that airline seat prices skyrocketed. Always be sure to consider both supply and demand when trying to anticipate what will happen to price. Both forces count.
Now that we have the necessary economic concepts behind us, we can move closer toward our goal of understanding interest rates. We’ll start by taking a look at the U.S. banking system along with the Federal Reserve, and see how these institutions regulate the flow of money in the economy and how that regulation affects the price of money – the interest rate.