Traders’ action is based on a reservation price to maximize final period expected utility,
given the auction rules and information. The reservation price derives from the valuation
of an asset. The actions that can increase trader utility are: (1) sell at market bid if it
exceeds one’s valuation plus the price at which s/he bought the permit, (2) buy at market
ask if it is below the buyer’s valuation of the permit, (3) raise the market bid if a trader
does not own it and it is below the valuation of the permit and (4) reduce the market ask
if a trader does not sell it and it is above the cost of the permit.
Exchange occurs as long as the buyer’s valuation exceeds the seller's cost and stops when
the seller's cost is higher than the buyer's valuation of the permit. To illustrate the trading
behavior, Figure 1 shows the exchange whenever valuation exceeds cost.2 Intra-marginal
trade or mutual profitable exchange occurs between buyers 1, 2, 3, 4 and 5 and sellers 12,
13, 14, 15 and 16. If buyer 2 buys from seller 14, buyer 2 can resell the permit at least at
the valuation level. The arrow in the Figure shows buyer 2 reselling the permit at a price
at least equivalent to the valuation level. Seller 14 can buy again in the market and bid
the most at the valuation level. For example, if the equilibrium price interval is [15, 16],
if buyer 2 buys at price 15 from seller number 14 and his/her own valuation is 25, buyer
2 would resell the permit at least at the price of 25. Seller 14 whose valuation is 10,
would then buy another permit from the market costing no more than the price of 10.
This same process of buying/selling based on reservation price or valuation continues as
long as cost of selling remains below the valuation of the buyers. This mechanism
insures that high value traders purchase from low value traders and that permits are
allocated from low cost sellers to high value buyers.
2
The demand curve depicts the valuation and the supply curve represents the cost of sellers.
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