Smart market

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 McCabe et al. (1991).^[1]

Combinatorial auctions are smart markets in which goods are indivisible,^[2] 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.