The difference between a single transaction and a market

Welcome to another new module of Smart Money. In this module, we’re going to be taking a closer look at the market and the orders that make it up. To begin with, let’s discuss a common example. 

A representative example of a single transaction

Smita has just purchased her dream home, and she’s out shopping for customized furniture. She has made some enquiries among her friends, family and local contacts, and she’s obtained the details of a local craftsman - Prem - who makes personalized, tailor-made furniture. In fact, that’s his specialty. So, Smita visits Prem’s workshop and explains to him what her requirements for a customized bookshelf are. Prem asks her for a couple of day’s time to draw up the blueprint and get a quote ready.

So, two days later, she heads back to the workshop, where Prem quotes the price as Rs. 40,000. Believing it to be on the steeper side, Smita begins a negotiation. They go back and forth between themselves, and finally, they settle for Rs. 32,000, of which Rs. 5,000 would be paid in advance. Smita, for her part, requires the bookshelf completed in a week’s time. And with these conditions, they enter into a contract.

This is what a single transaction would be like typically, isn’t it? If there’s only one buyer and one seller involved, there’s plenty of room for negotiating the details, customizing the contract and laying down specific conditions. 

So, technically, what is a single transaction?

A single transaction in any kind of market is a unique trade that occurs between a buyer and a seller. The buyer and the seller involved have complete freedom to set the price for the product or service they are trading. The factors influencing this price are limited to the needs of the buyer and the seller. In other words, there are no external factors that come into play. 

Now, let’s switch things up a bit using two other possible scenarios.

Scenario 1: Competition for Smita, the buyer

Let’s assume that in the two days that Prem asks for getting the blueprint and the sketch ready, another interested customer - Asha - walks into his shop. Asha wants a similar customized bookshelf. But she is willing to pay Rs. 38,000 for it.

Two days later, when Prem, the craftsman, quotes his price to Smita, his first customer, he’s going to negotiate down to Rs. 38,000 at best. That’s because he has another customer - Asha - who is willing to pay the same price. This limits Smita’s negotiating power, because she has competition from another buyer.

Scenario 2: Competition for Prem, the seller

Now, let’s shuffle things for the seller. Let’s assume that in the two days that Prem asks for getting the blueprint and the sketch ready, Smita chances upon another local craftsman who can make her the customized bookshelf she wants. This new craftsman - Raghu - only charges Rs. 30,000 for it.

Two days later, when Prem, the first craftsman, quotes his price of Rs. 40,000 to Smita, she is unwilling to pay anything more than Rs. 30,000. That’s because she knows another craftsman - Raghu - who is willing to charge the lower price. This limits Prem’s negotiating power, because he has competition from another seller.

In both the scenarios discussed above, the presence of multiple buyers and/or sellers gives rise to a market. Let’s dig a little deeper and find out how markets work. 

So, what is a market?

A market is a space that consists of multiple buyers and sellers. It is defined as a gathering of people to facilitate the exchange or the trade of goods and services. The trade can either occur as a result of the buyers and sellers being in direct contact with one another, or, it can occur through intermediary agents who facilitate the transactions.

Direct trades are the norm, in most markets. For example, take your local markets, a farmers’ market, or even a retail outlet. You directly interact with the sellers to make your purchase, isn’t it? On the other hand, in other markets like the stock market, there are intermediaries like stock exchanges that facilitate trading.

How are the prices in a market determined?

Have you ever noticed how the prices of products in your local grocery or vegetable market are constantly fluctuating. Take apples, for instance. Today, if you visit the market, you may find that apples are sold at Rs. 120 per kg. A week later, the price may go up to Rs. 140. And then, another week down the line, it may drop to Rs. 130 per kg. 

Now, how are these prices determined when there are multiple buyers and sellers involved? There are many factors that come into play here. But the two most crucial driving factors that influence the prices of goods and services are supply and demand.

Supply refers to how much of something the market has, while demand is how much of something the market wants.

• If the supply is high, it means there are more sellers in the market than there are buyers. With limited buyers to sell to, sellers will naturally be ready to lower the prices of their goods and services to appeal to the buying population. This brings down the prices of goods and services.
• On the other hand, if the demand is higher than the supply, there are more buyers than sellers. With only limited sellers to buy from, buyers will need to compromise and purchase the products or services at the prices that sellers offer. And sellers have the freedom to up the prices, leading to rising costs of goods and services.

So, let’s sum it up.

A single transaction vs. the whole market: The bottom line

So, what this shows us is that in a single transaction, the buyer and the seller each have equal freedom to set the price for the goods or services being traded. But in a market, there are multiple buyers and sellers. 

This means that when you go into the market with the intention of buying a product, there will be many other people competing with you to buy the goods too. If the supply is limited, the product(s) will be sold to the buyers who bid the highest. For example, say a seller has 3 watches to sell. But there are 8 buyers, bidding at the following prices.

In this case, the seller will obviously sell his wares to the buyers bidding at the top 3 buyers. That would be:

• Buyer 7, bidding at Rs. 1,100
• Buyer 3, bidding at Rs. 1,000
• Buyer 5, bidding at Rs. 970

Now, let’s turn the situation around and assume that you want to buy a watch. And there are 8 sellers, each offering different prices for the product, as follows.

If this is the case, you will naturally buy the watch from Seller 2, because they offer the lowest price.  

Basically, sellers gravitate to the buyers that bid the highest, and buyers gravitate to sellers that offer the lowest prices.

What does this mean for investors in the stock market?

The stock market is, well, a market. So, as an individual trader or investor, there’s little control that you have over the prices at which stocks trade in the market. Stock prices are determined by the market as a whole, and by the demand and supply forces driving the market. 

This is important to know because it is easy to forget that often, as an investor or a trader, no matter how strong your research may be, you are at the mercy of the market. You may perform an in-depth analysis and come to the conclusion that the price of a stock may rise up to, say Rs. 200 by the market close today. But if there’s a major change in the demand or the supply, the market will move in a manner you couldn’t predict.

Wrapping up

So, does this mean that research is pointless? No, not at all. What this means is that despite the most thorough research, it’s always a smart idea to leave room for some error on both sides. After all, speculation and trading is not an exact science. But the process of buying and selling an asset on the stock market is. And that is just what we’re going to see in the coming chapter.

A quick recap

• A single transaction in any kind of market is a unique trade that occurs between a buyer and a seller. 
• The buyer and the seller involved have complete freedom to set the price for the product or service they are trading. 
• The factors influencing this price are limited to the needs of the buyer and the seller. In other words, there are no external factors that come into play. 
• A market is a space that consists of multiple buyers and sellers. It is defined as a gathering of people to facilitate the exchange or the trade of goods and services. 
• The trade can either occur as a result of the buyers and sellers being in direct contact with one another, or, it can occur through intermediary agents who facilitate the transactions.
• The two most crucial driving factors that influence the prices of goods and services are supply and demand.
• Supply refers to how much of something the market has, while demand is how much of something the market wants.
• Basically, sellers gravitate to the buyers that bid the highest, and buyers gravitate to sellers that offer the lowest prices.