Smart market
Encyclopedia
A "smart market" is a periodic auction
which is cleared by the operations research
technique of mathematical optimization
, such as linear programming
. The smart market is operated by a market manager. Trades are not bilateral, between pairs of people, but rather to or from a pool. A smart market can assist market operation when trades would otherwise have significant transaction costs or externalities.
Most other types of auctions can be cleared by a simple process of sorting
bids from lowest to highest. Goods may be divisible, as with milk or flour, or indivisible, as with paintings or houses. Finding a market-clearing allocation corresponds to solution of a simple knapsack problem
, and does not require much computation. By contrast, a smart market allows market clearing
with arbitrary constraints. During market design, constraints are selected to match the relevant physics and economics of the allocation problem. A good overview is given in .
Combinatorial auction
s are smart markets in which goods are indivisible , but some smart markets allocate divisible goods such as electricity and natural gas.
Compared to traditional market structures, a smart market substantially reduces transaction costs, allows competition which would not be possible otherwise, and can eliminate externalities. Despite complex constraints, a smart market allows the benefits of a modern financial exchange system. Fulfilment of the contract is backed by the exchange; parties are generally anonymous; the market manager enforces regulation to ensure fairness and transparency; and markets are orderly, especially during stressful conditions.
A smart market may be a one-sided auction in which participants buy from the market manager, a one-sided procurement
(reverse auction
) in which participants sell to the market manager, or two-sided, in which the market manager balances supplying participants with demanding participants. In a two-sided smart market, the market manager may be a net seller, a net buyer, or simply a revenue-neutral broker.
Smart markets are achievable due to an enabling confluence of technologies: the internet to transmit users’ bids and the resulting prices and quantities, increased computation power to run the simulation and linear program, and real time monitoring.
for airplane take-off and landing slots. The U.S. government is now seeking to implement such an auction.
The modern electricity market
is an important example of a two-sided smart market. , Electricity markets clear every few minutes, and require coordination to ensure that power generation
matches demand, and that power flows do not exceed network line capacities. Generators offer to supply tranches of power at a range of prices. Wholesale power distributors bid to buy tranches of power at a range of prices. To clear the market, the market manager solves a linear program in which the decision variables are how much power to accept from each generator, the flow of power on each line, and how much power to provide to each distributor.
After solution, the primal variables prescribe the dispatch (that is, how much power each generator should produce). The dual variables provide the market clearing prices. By clearing the market based on the dual prices, participants are charged on marginal values, rather than as bid. Thus, every seller is guaranteed to receive at least as much as was bid and possibly more. Every buyer is guaranteed to pay no more than was offered, and possibly less. Without the smart market, the line operator, all generators, and all distributors would have to be part of a monopoly
in order to guarantee system coordination.
Natural gas
markets are sometimes cleared by smart markets , as in Australia http://www.vencorp.com.au. The system operator serves as the market manager. Operation of the gas pipeline network require coordination to ensure that gas supply matches demand, and that flows do not exceed pipe capacities. Gas suppliers offer a range of quantities at a range of prices. Distributors bid to buy a range of quantities at a range of prices. To clear the market, the market manager solves a linear program in which the decision variables are the gas to accept from each supplier, the flow of gas on each pipe segment, and how much gas to provide to each distributor. As with electricity markets, after solution, the primal variables prescribe the optimal flows, and the dual variables provide the market clearing prices. The objective minimizes the cost of supplying power.
The spectrum auction
is a one-sided smart market which is cleared by an integer program. Participants purchase radio spectrum from government. These combinatorial auction
s are cleared as bid, rather than at prices based on dual variables. Only recently have researchers found robust means to obtain dual variables from integer programs.
Companies and governments sometimes use smart markets in procurement, as for transportation services. The Chilean government, for example, uses a smart market to choose caterers for school meal programs . The University of Chicago Booth School of Business uses a smart market for course registration. The system ensures that the class seats go to those students who most want them, while ensuring that the number of students in each class stays within the room capacity.
Smart markets are now being proposed for environmental services, including water , The more sophisticated of these designs rely on hydrological optimization
and hydrological run-off models.
.
See also mechanism design
.
Auction
An auction is a process of buying and selling goods or services by offering them up for bid, taking bids, and then selling the item to the highest bidder...
which is cleared by the operations research
Operations research
Operations research is an interdisciplinary mathematical science that focuses on the effective use of technology by organizations...
technique of mathematical optimization
Optimization (mathematics)
In mathematics, computational science, or management science, mathematical optimization refers to the selection of a best element from some set of available alternatives....
, such as linear programming
Linear programming
Linear programming is a mathematical method for determining a way to achieve the best outcome in a given mathematical model for some list of requirements represented as linear relationships...
. The smart market is operated by a market manager. Trades are not bilateral, between pairs of people, but rather to or from a pool. A smart market can assist market operation when trades would otherwise have significant transaction costs or externalities.
Most other types of auctions can be cleared by a simple process of sorting
Sorting
Sorting is any process of arranging items in some sequence and/or in different sets, and accordingly, it has two common, yet distinct meanings:# ordering: arranging items of the same kind, class, nature, etc...
bids from lowest to highest. Goods may be divisible, as with milk or flour, or indivisible, as with paintings or houses. Finding a market-clearing allocation corresponds to solution of a simple knapsack problem
Knapsack problem
The knapsack problem or rucksack problem is a problem in combinatorial optimization: Given a set of items, each with a weight and a value, determine the count of each item to include in a collection so that the total weight is less than or equal to a given limit and the total value is as large as...
, and does not require much computation. By contrast, a smart market allows market clearing
Market clearing
In economics, market clearing refers to either# a simplifying assumption made by the new classical school that markets always go to where the quantity supplied equals the quantity demanded; or# the process of getting there via price adjustment....
with arbitrary constraints. During market design, constraints are selected to match the relevant physics and economics of the allocation problem. A good overview is given in .
Combinatorial auction
Combinatorial auction
A combinatorial auction is a type of smart market in which participants can place bids on combinations of discrete items, or “packages,” rather than just individual items or continuous quantities....
s are smart markets in which goods are indivisible , but some smart markets allocate divisible goods such as electricity and natural gas.
Compared to traditional market structures, a smart market substantially reduces transaction costs, allows competition which would not be possible otherwise, and can eliminate externalities. Despite complex constraints, a smart market allows the benefits of a modern financial exchange system. Fulfilment of the contract is backed by the exchange; parties are generally anonymous; the market manager enforces regulation to ensure fairness and transparency; and markets are orderly, especially during stressful conditions.
A smart market may be a one-sided auction in which participants buy from the market manager, a one-sided procurement
Procurement
Procurement is the acquisition of goods or services. It is favourable that the goods/services are appropriate and that they are procured at the best possible cost to meet the needs of the purchaser in terms of quality and quantity, time, and location...
(reverse auction
Reverse auction
A reverse auction is a type of auction in which the roles of buyers and sellers are reversed. In an ordinary auction , buyers compete to obtain a good or service, and the price typically increases over time...
) in which participants sell to the market manager, or two-sided, in which the market manager balances supplying participants with demanding participants. In a two-sided smart market, the market manager may be a net seller, a net buyer, or simply a revenue-neutral broker.
Smart markets are achievable due to an enabling confluence of technologies: the internet to transmit users’ bids and the resulting prices and quantities, increased computation power to run the simulation and linear program, and real time monitoring.
Examples of smart markets
The term appears to have been first used by Rassenti, Smith, and Bulfin in 1982 . That article proposed a combinatorial auctionCombinatorial auction
A combinatorial auction is a type of smart market in which participants can place bids on combinations of discrete items, or “packages,” rather than just individual items or continuous quantities....
for airplane take-off and landing slots. The U.S. government is now seeking to implement such an auction.
The modern electricity market
Electricity market
In economic terms, electricity is a commodity capable of being bought, sold and traded. An electricity market is a system for effecting purchases, through bids to buy; sales, through offers to sell; and short-term trades, generally in the form of financial or obligation swaps. Bids and offers use...
is an important example of a two-sided smart market. , Electricity markets clear every few minutes, and require coordination to ensure that power generation
Generation
Generation , also known as procreation in biological sciences, is the act of producing offspring....
matches demand, and that power flows do not exceed network line capacities. Generators offer to supply tranches of power at a range of prices. Wholesale power distributors bid to buy tranches of power at a range of prices. To clear the market, the market manager solves a linear program in which the decision variables are how much power to accept from each generator, the flow of power on each line, and how much power to provide to each distributor.
After solution, the primal variables prescribe the dispatch (that is, how much power each generator should produce). The dual variables provide the market clearing prices. By clearing the market based on the dual prices, participants are charged on marginal values, rather than as bid. Thus, every seller is guaranteed to receive at least as much as was bid and possibly more. Every buyer is guaranteed to pay no more than was offered, and possibly less. Without the smart market, the line operator, all generators, and all distributors would have to be part of a monopoly
Monopoly
A monopoly exists when a specific person or enterprise is the only supplier of a particular commodity...
in order to guarantee system coordination.
Natural gas
Natural gas
Natural gas is a naturally occurring gas mixture consisting primarily of methane, typically with 0–20% higher hydrocarbons . It is found associated with other hydrocarbon fuel, in coal beds, as methane clathrates, and is an important fuel source and a major feedstock for fertilizers.Most natural...
markets are sometimes cleared by smart markets , as in Australia http://www.vencorp.com.au. The system operator serves as the market manager. Operation of the gas pipeline network require coordination to ensure that gas supply matches demand, and that flows do not exceed pipe capacities. Gas suppliers offer a range of quantities at a range of prices. Distributors bid to buy a range of quantities at a range of prices. To clear the market, the market manager solves a linear program in which the decision variables are the gas to accept from each supplier, the flow of gas on each pipe segment, and how much gas to provide to each distributor. As with electricity markets, after solution, the primal variables prescribe the optimal flows, and the dual variables provide the market clearing prices. The objective minimizes the cost of supplying power.
The spectrum auction
Spectrum auction
A spectrum auction is a process whereby a government uses an auction system to sell the rights to transmit signals over specific bands of the electromagnetic spectrum and to assign scarce spectrum resources. Depending on the specific auction format used, a spectrum auction can last from a single...
is a one-sided smart market which is cleared by an integer program. Participants purchase radio spectrum from government. These combinatorial auction
Combinatorial auction
A combinatorial auction is a type of smart market in which participants can place bids on combinations of discrete items, or “packages,” rather than just individual items or continuous quantities....
s are cleared as bid, rather than at prices based on dual variables. Only recently have researchers found robust means to obtain dual variables from integer programs.
Companies and governments sometimes use smart markets in procurement, as for transportation services. The Chilean government, for example, uses a smart market to choose caterers for school meal programs . The University of Chicago Booth School of Business uses a smart market for course registration. The system ensures that the class seats go to those students who most want them, while ensuring that the number of students in each class stays within the room capacity.
Smart markets are now being proposed for environmental services, including water , The more sophisticated of these designs rely on hydrological optimization
Hydrological optimization
Hydrological optimization applies mathematical optimization techniques to water-related problems. These problems may be for surface water, groundwater, or the combination...
and hydrological run-off models.
Formulations
A smart market formulation may be written as a net pool, in which the decision variables explicitly calculate buys and sells, and the market model clears only those quantities. The net pool market can be mathematically infeasible if participants are unwilling to trade sufficient quantities to allow feasibility. Alternatively, the formulation may be a gross pool, in which the decision variables determine total quantities that each participant receives; the market manager calculates net sales after the model's solution, based on participants' initial holdings. The gross pool market will tend to be mathematically feasible, but could have an unacceptably high cost in the optimal objective value, should (buy) bids be too low compared to (sell) offers. The difference between these two formulations is only technical, as the market designs are economically equivalent by the Coase theoremCoase theorem
In law and economics, the Coase theorem , attributed to Ronald Coase, describes the economic efficiency of an economic allocation or outcome in the presence of externalities. The theorem states that if trade in an externality is possible and there are no transaction costs, bargaining will lead to...
.
See also mechanism design
Mechanism design
Mechanism design is a field in game theory studying solution concepts for a class of private information games...
.