Supply and Demand in the Stock Market

Jenna Doucet (March 2010).

Supply and Demand in the Stock Market

In most industries the law of supply and demand is an accepted theory to explain the price of products and services. One industry that overlooked the significance of the law of supply and demand in the past is the stock market. Experts attributed the Stock Bubble of the 1990s to an overly simple theory; it was believed that rising prices in stocks were caused by an underlying rise of companies’ value. The price of stocks in the 1990s is today better understood as derived from a shortage of equities in the market (Oswin, 2005). The law of supply and demand is a fundamental concept in economics that explains market factors such as the quantity of a product or service demanded by consumers, the supply of products or services that suppliers are willing to produce and the relationship between supply and demand to create market equilibrium. The law of supply and demand also tries to explain what conditions in the market create changes in quantity demand and supplied in the market (Colander, 2008).

In his essay, The Relative Shortage of Equities, Oswin (2005) describes some of the conditions that affect stock market activity and explains the theories behind the demand and supply of equities, which drive the prices of the market. According to Oswin (2005), the law of supply and demand is the cause behind bear and bull markets. Investors use the term bear market to describe markets in which the prices of stocks are stubbornly declining. A bull market is characterized by a strong upward trend in the prices of stocks. According to the law of supply and demand, the increase in the price of a product is caused by a shortage of supply or excess demand, and a decline in price is associated with a surplus in supply or a decrease in demand (Colander, 2008). Oswin (2005) states that during the Great Stock Bubble “ Investors’ determination to buy equities exceeded issuers willingness to satisfy their demand for stocks” (p. 4). Furthermore, Oswin (2005) notes, “issuers competed with investors in buying back company shares, contributing to the shortage” (p. 4).

What is unique about the stock market is that the value of securities is largely dependent on speculation. In essence market expectations are what drive the demand and supply of securities. Thus, understanding how the law of supply and demand affects stock prices is much more complex than in other industries. To simplify, it can be said that when investors expect market prices to rise and believe they can make a profit, the demand for securities will also rise, the opposite is true when individuals expect declining prices. The law of demand also states that when prices are lower demand rises, and this is also true for securities when combined with reinforcing market expectations. A lower price for a security, especially when that security is expected to increase in value will cause a rise in demand. On the supply side, issuing companies are more apt to sell securities when the price of their stock will be high as to maximize capital to finance growth. This is in accordance with the law of supply that states supply increases when prices are high and profits are expected to increase. However, the demand for supply is also affected by outside forces such as a company’s need for raising capital. If a company has enough capital to finance growth operations and does not need to borrow, there will be no need for companies to issue additional securities. In a booming market, in which corporate profits are steady and growing, and the need for issuing additional securities is low, stocks will be in high demand and prices will rise. Additionally, sellers and buyers of securities in the secondary market create supply in the market. When prices are rising, investors are willing to hold on to their stocks for longer periods of times and there is a shortage of sellers. When prices are declining, investors are more eager to sell their securities to protect their paper profits or to minimize exposure. Equilibrium of price is created when potential buyers willingness to pay for a security matches what suppliers are willing to sell their securities for.

References

Colander, D. C., (2008). Economics (7th ed.). New York: McGraw-Hill.

Oswin, J. (2005). The relative shortage of equities. Capital flow Analysis. Retrieved onMarch 13, 2010 from: http://www.capital-flow-analysis.com/investment-theory/shortage-of-equities.html