Markets allow participants to make trades that they perceive as having value to them, whether for future investment or for their own use. A combination of factors combine to prevent markets from operating at maximum efficiency. When two goods are exchanged, it requires two traders. One is considered a buyer, one is considered a seller. They need to locate each other and then agree on a price. The buyer wants to pay as little as possible, while the seller wants the buyer to pay as much as possible. Neither side can be sure what the other is willing to accept, and both sides have strong incentives to misrepresent the value of the good or what price they will accept in order to get a better price. Both sides fear being cheated. There is also often considerable cost in this process of locating the other trader and negotiating with them. These effects combine to prevent many trades from occurring even when both sides would prefer to trade at a deviation from their perceived value.
Most participants in a market are either buying or selling the good being traded. Few if any participants are willing to buy or sell depending on the price, and even those who do so generally require a wide and favorable differential or spread in the price he will pay for the good and the price he will pay to purchase it. There is nothing forcing participants to refine their valuation of the good and all trades need to be beneficial enough to overcome status quo bias. Those who approach the market as buyers or sellers know how much they value the good being traded, but that information is not enough to trade in the market and still get full value. A trader must know the market price, locate someone willing to engage in the opposite transaction (a buyer if they wish to sell, a seller if they wish to buy) and then negotiate a price for the exchange. In the extreme case, with a minimal number of buyers or sellers, trades often do not take place at all because of the need to overcome this asymmetrical information even when there would be a lot of value in a trade. These factors do not generally change based upon the number of participants, i.e. when the market is large.
The standard market structure for a financial market like a currency or stock exchange is that a buyer offers a price he would pay, known as a “bid”, while the seller offers a price he would accept, known as an “ask.” A potential trader has two choices. He can accept a bid or ask price and trade at that price, which normally means sacrificing value to make a trade, or he can enter a bid or ask of his own and hope someone else agrees to match it. Each participant faces a dilemma, balancing the desire to make a trade, to make it quickly and to make it at the best possible price. Much time and effort is lost as trades are delayed or do not happen for fear of ending up with a poor price or are sacrificed for the chance at an exceptional price.
Often the result of this situation is that the market price is not one price but two. There are many who are willing to sell at what is considered the asking price, and there are many who are willing to buy at what is called the bid price. This gap between the bid and the ask represents the inefficiency of the market: The true value of the good lies somewhere between the bid and the ask. Many markets will therefore only trade when a participant wants to trade enough that the participant is willing to pay the asking price or sell for the bid price. This is often what happens when someone needs to execute a trade quickly and thereby seeks a trade “at market.” In other cases, someone who wants to trade will ask or bid at a price in between the accepted bid and ask prices, hoping someone will accept the proposed compromise. At other times, the transaction costs involved in the market force the price to be sufficiently non-continuous that there can be no compromise price: For example, a stock can only trade at certain fractions of a dollar per share, and you can sell large quantities easily at one price and buy large quantities easily at the next permissible number.
The problem here in large part stems from the distinction between buyers and sellers. Even those who are willing to both buy and sell act almost as if they were two distinct traders, one who is a buyer and one who is a seller. As a buyer, you try to keep the price low while as a seller you want to keep the price high. However, that is not generally why a potential trader comes to the market—they come to the market because they believe that the two goods being exchanged have a different relative value than they do on the open market. This may be because the current market price does not reflect the future market price, in which case the prospective trader acts as an investor or speculator. It could also be because you can gain utility out of a good in excess of its cost at market, either by using it or reselling it at a different market. Ultimately, that is what markets are for, to get goods into the hands of those who have the most valuable use for them.
The standard implementation of a market for gambling on the outcome of an event shares, being similar in many respects, many of the same problems. The person who runs the market is known as the bookie and he offers a buy and an ask price. Participants trade by accepting either the bid or the ask price, which are generally separated by a standard gap of between a minimum of 2% and often 5% or more. This large gap is necessary to compensate them the bookie for the exposure they face if they have miscalculated the price or if an event causes a change that results in a drastic unbalancing in the number of trades. Only very confident traders are willing to pay such high transaction costs and there are entire categories of trades that do not happen at all because this gap acts as a barrier.
To summarize the inefficiencies of current market systems, they (1) give some or all participants incentive to misrepresent the value of the good being traded; (2) allow participants to be taken advantage of by those who have better information about the state of the market; (3) add greatly to the cost of transactions, making the cost of market participation potentially prohibitive depending on how much a traders' valuation differs from the markets'; (4) require buyers and sellers to locate each other and negotiate terms; (5) do not allow for extremely fine distinctions in price; (6) require the prediction of a large fluctuation in price before that prediction is sufficient to cause a potential participant to trade and provide that information to the market due to the need to overcome transaction costs in both directions; (7) completely eliminate entire types of trades due to their inability to consistently overcome those transaction costs; (8) reinforce the natural human tendency towards status quo bias; (9) are sufficiently inefficient to prevent the creation of some markets despite the potential mutual profitability of trades; (10) fail to create a single number that accurately reflects market value. Thus, there is an ongoing need for approaches that can address one or more of these inefficiencies so that trades can happen among those desiring to do so.