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The Economics of the Stock Market Pt. 1

Understand the concepts that move the market:
Supply and Demand

"The law of supply and demand is more important than all the analyst opinions on Wall Street."  - William J. O'Neil

The price of everything in our capitalist society comes down to a simple equation - the interaction of supply and demand. And the stock market is no exception. In fact, the law of supply and demand is probably more visible in the stock market than in any other market.

Consider your neighbourhood supermarket. There the price of carrots or a can of soup may seem unfathomable. That is because in most cases, the famous invisible hand of Adam Smith controls prices. We do not know all the details that have gone into determining the price - the weather in growing areas, the incidence of insects that destroy crops, the scarcity of tin and its effect on the price of cans.

We cannot simply draw a chart to see where the price of a can of soup is and where itís going. They just donít make soup charts or carrot charts although such information may be available to farmers and grocers in specialized publications.  But the stock market is different.  The prices change quickly through a constant auction process. The interplay of buyers and sellers can be seen in stock charts. These charts, as we shall see, represent the law of supply and demand in action.

But first, letís get back to basics. Some wags have said that economics is an inexact science, nay, even a dismal science. Ask an opinion of ten different economists and youíll get ten different answers. Economics is held by many to be in disrepute. Or at least arcane and incomprehensible. But what theyíre talking about is what is usually known as macro-economics - an attempt to look at the big picture. And that usually involves politics.

What economists of all stripes universally agree on though, is micro-economics. The building blocks and foundation of economics - the law of supply and demand. Call it Economics 101. In this writerís opinion, it is the only economics that matters because, at core, it explains everything, even the diverse opinions of the macro-economists.  How can that be?  The opinions of the macro-economists depend on certain assumptions, and given these assumptions are correct, their conclusions are correct. The problem is different economists make different economic assumptions.

So letís get on to the only economics that matters - micro-economics. For those familiar with the subject, it will be a handy refresher.  For novices, the explanation should be clear and easy to follow and lay the groundwork for parts two and three of the article.

Economics 101

In a nutshell, all other things being equal, a seller will prefer to get a higher price for his product rather than a lower price. And conversely, a buyer prefers to pay less for the goods he buys rather than more.

Thatís it.  Lesson over.  Class dismissed!

What, you say? Thatís it?  But when I took Economics 101 in university they gave us a big huge textbook, hundreds of pages of excruciating boredom!

That may well be, but the above lesson is the essence of economics. Everything else is elaboration on this theme. So letís elaborate briefly.

A key part of the lesson is ďall other things being equalĒ.  Thereís the rub. They never are.

Letís consider the concept of supply. The law of supply says that sellers prefer higher prices. One corollary is that, if prices rise, more sellers are attracted to the market, increased supply will be available, and competition for customers will pull prices down again.

Suppose there are a certain number of people making the economistís favourite product - widgets. Theyíre selling at a certain price, but the widget makers realize that people really like widgets and that they can raise the price of widgets and still sell them all. So they do.

What happens now is that potential widget makers who found the previous profit level of widget manufacturing to be uneconomic will now start making widgets. The supply will increase. But people donít want any more widgets than they did before, so some go unsold. In order to sell all their widgets, the manufacturers start lowering their prices.

Letís look at it from the demand side.  People really like widgets so the manufacturers raise prices. They still sell all of them. But they get greedy and raise the prices even more. Now some of the widget consumers say ďForget it! Iím not paying that high a price for widgets.Ē So manufacturers are left with unsold widgets and are forced to reduce their prices to sell them all.

This interplay of buyers wanting to pay less and sellers wanting to charge more is the law of supply and demand in action.

It explains why stores put things on sale when they are not selling well. The rationale is that a lower price will induce more people to buy.  It also explains why a shortage of a product, say oranges because of a bad crop due to unseasonable weather, causes the price to rise.  With lots of oranges (supply) in the market, the growers must charge a certain price to sell them all.  But some of those consumers of oranges are actually willing to pay more for their oranges.  Not everyone, but some. When the supply falls because of bad weather, the orange growers donít have to worry about the people who only want cheap oranges. They can charge a higher price because the number of people willing to pay the higher price will buy all of the smaller number of oranges.  But they canít raise the price indiscriminately.  If they raise the price too much, theyíll still be stuck with unsold oranges.   

This interplay of buyers and sellers can be graphically depicted as shown below.   

The line sloping from the upper left to the lower right is the demand curve. The line sloping from the lower left to the upper right is the supply curve.  They show that widget manufacturers are willing to produce more widgets as the price goes up. And conversely, widget consumers want to purchase more widgets as the price goes down.  Equilibrium, in this example, is 65 widgets at $7.

If widget manufacturers charge a higher price, they will be left with unsold widgets. If they charge a lower price, the widgets will sell out quickly and there will be a shortage. So whenever a price different than the equilibrium price is charged, someone will be unhappy. Interestingly enough, it is not the people you might expect to be unhappy.  If the price is too high, producers are unhappy because they are left with unsold stock and high inventories and must cut back production. If the price is too low, consumers are unhappy because they canít get all the widgets they want.

Putting this into numbers, if the price charged is $10, only 30 widgets will be sold.  Manufacturers produced 65 and are stuck with 35 left over. If the price is only $5, widget consumers want 100 widgets but can only get 65.

So how, you might ask, do prices change? Prices change when the whole supply or demand curve shifts. If a successful advertising campaign convinces consumers that they just need to have a widget and consumers are willing to pay more, then the demand curve shifts to the right. Prices go up. Conversely, if consumers want less of the product - the product was a fad such as the pet rock or the hula hoop - the demand curve shifts to the left.  Prices fall.

On the supply side, if manufacturers canít produce at the current market price because it doesnít cover their costs, they will cut back production. The supply curve shifts to the left.  Conversely, if improved technology lets producers cut costs, they will be able to cut prices while maintaining profit margins.  At a lower price, customers will be willing to buy more, so the producers oblige and make more. The supply curve shifts to the right.

All of these other factors are the other things that are never equal, as Iíve noted.  The interplay of all these factors make for shifting supply and demand curves and even changes in the shape of the curves.  This dynamic flux creates the price structure of the capitalist market system.

It is a thing of beauty to contemplate because all of the myriad changes in fashions, technology, costs of production, and so on interact to produce the right price at the right time as if by an invisible hand - just as Adam Smith put it so brilliantly. We might gripe about the price of oranges going up, but if it didnít, we would soon find ourselves with a shortage.

Letís review some of the concepts and ideas weíve covered about supply and demand.

Supply

All things equal, sellers prefer higher prices to lower prices.

All things are never equal, but in constant flux.

Some of the things that change on the supply side are

  • costs of production

  • weather

  • transportation costs

  • technology changes

  • changes in wage rates

  • success or failure of advertising campaigns

Demand

All things equal, buyers prefer lower prices to higher prices.

All things are never equal but in constant flux.

Some of the things that change on the demand side are

  • increased or decreased wealth of the consumer
  • change in tastes, fashions and fads
  • new knowledge about competing products
  • decisions to substitute one product for another because of such knowledge (e.g. - substituting margarine for butter)

These lists are examples of factors affecting supply and demand and are not exhaustive.

The question now is, how does supply and demand affect the stock market. Here are some general principles to consider.

Part 2: Supply and Demand and the Stock Market
Part 3: What the Charts Tell Us

 

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