Market forces, know as supply and demand, play a significant role in the determination of price. Understanding the basics of economics can assist an investor in two ways:
- The stock investor is able to make an educated assessment of where the economy and financial markets are in the current economic cycle. And therefore, which asset classes will most likely offer the greatest return,
- The stock investor (and trader) will be better placed to understand which side of the market is driving a stock’s price. For example, is it the supply side or underlying demand that is currently moving a stock’s price?
Before we can begin to make an assessment, we must first understand the fundamental principle of economics.
Economics is generally referred to as the study of the way in which scarce resources are allocated amongst competing uses. The basic premise of economics revolves around price and the interaction between supply and demand.
The Fundamental Economic Principle: Price, Demand and Supply
Fig 1: Demand Curve
Demand is inversely related to price
Consumers’ willing to purchase (in economic terms is known as demand) goods and services are influenced by a variety factors such as household income, consumer tastes, cost and availability of substitute products, and cost and availability of credit.
Whilst all these factors play a part in influencing consumer buying habits, the most important factor affecting demand for any good or service is usually its price.
As the price of a good (or service) increases the demand for that product usually decreases. In other words, price is inversely related to price. When displayed graphically, demand is plotted as a negatively sloped curve.
Figure 1: demonstrates the difference in demand for a change in price from $15 to $35 for the same item. At $15 demand is 40 units, this falls to 15 units when the price is increased to $35.
Supply is positively related to price
A producer’s willingness to produce (known as supply) goods and services to sell to consumers is influenced by the cost of production, technology and distribution. However, producers are not interested in producing items
Fig 2: Supply Curve
just too break-even. A producer’s main goal is to make a profit. Therefore, the most important determinant of a producer’s willingness to produce an item is its price.
As the price of a good (or service) increases there will be more producers willing to produce the item. In other words, as price increases so will supply. So, price is considered to have a positive relationship with supply. When displayed graphically, supply is plotted as a positively sloped curve.
Figure 2: demonstrates the difference in supply for a change in price from$15 to $30 for the same item. At $15 only 10 units are supplied, however when price increase to $30 supply jumps to 30 units.
Equilibrium Price
The fundamental principle of economics states that the actual quantity of an item demanded and supplied is determined by the intersection of the supply and demand curves. The price at which the supply and demand curves intersect is known as the equilibrium price figure 3. At this price, the market is said to be in a state of equilibrium (i.e. in balance).
Any changes in the non-price factors influencing supply or demand will disturb the equilibrium by shifting the supply or demand curve either up or down.
Fig 3: Equilbrium Price
When this occurs, market forces quickly bring supply and demand back into balance and a new equilibrium point is established.
A common example demonstrating the effects of a market in disequilibrium (imbalance) is when a stock price suddenly ‘breaks out’ of a trading range (area of price equilibrium) and moves higher (or lower) on heavy volume.
An increase in supply will lead to a fall in price (as supply exceeds demand). whilst, an increase in demand will lead to a rise in price (as demand exceeds supply). The change in supply or demand causes an imbalance which is reflected as a change in a stock’s price. This change creates a trading or investment opportunity from a technical analysis perspective.
In summary, what we have briefly explored here is the interaction of supply, demand, and price. This is a concept that every investor (and trader) should strive to comprehend. It is a concept that is revisited day-in and day-out in the stock market. It is the underlying principle behind identifying a profitable, future trade or investment.
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Figure 1: Demand curve, Source=Uk Wikipedia, Date= 29 Sep 2007, Author=uk:Minia, Public Domain
Figure 2: Supply curve, Source=Uk Wikipedia, Date= 8 Sep 2007, Author=uk:Minia, License GNU Free Documentation License
Figure 3: Illustrates the intersection of supply and demand curves as the free market equilibrium, Source=from en.wikipedia, Date=2006-11-28, Author=en:User:SilverStar, License Creative Commons Attribution 2.5
