Understanding Supply and Demand in the Stock Market
Sumedh Joshi, Neel Joshi : MIT World Peace University, Pune
Supply and demand can be considered one of the most basic functional and paramount tools to determine or anticipate the price of any financial security. Demand is created by people who are willing and able to buy various quantities of stock at various possible prices. On the other hand, supply is created by people who are willing and able to sell various quantities of stock at various possible prices. Fig. 1 shows the relation between supply and demand. The interaction between these buyers and sellers decides the price and overall position of the security or the market trend.
Law of Demand
This law establishes the inverse relationship between price and quantity demanded. This law states that “ceteris paribus, as the price of stock increases, the quantity demanded will decrease and if the price of stock decreases, the quantity demanded will increase.” Quantity demanded is the quantity that buyers are willing and able to buy at a specific price at a specific point in time. As shown in Fig. 2, if an investor is willing and able to buy Rs. 10000 worth of Stock X which is trading at Rs. 500 per share, he will be able to acquire 20 shares. Now, if the price of this Stock X falls to Rs. 400 per share, according to the law of demand, the quantity demanded will increase to 25 shares. This shows that if the price of a security falls, buyers can acquire more shares to satisfy the amount that they were willing and able to purchase.
Change in Demand Curve
Every demand curve is defined by a demand schedule. This demand schedule is the collection of prices, and the quantity demanded at that respective price. Fig. 3(a) and 3(b) represent the old demand schedule and new demand schedule for Stock Y, respectively.
When plotted on a chart, the demand curves for these demand schedules are as shown in Fig. 4.
It is evident from the chart that as the values in the demand schedule change, the entire demand curve for that financial security shifts. Here, the demand curve shifts towards the right indicating that a positive effect has influenced the demand to grow. Any negative effect will shift the demand curve to the left. These positive and negative effects are called as demand shifters. Fig. 5(a) and (b) show the positive and negative demand shifts respectively.
Demand Shifters
There are 5 widely known demand shifters which are as follows-
- Tastes and Preferences
Tastes and preferences in a particular stock influence the demand shift. For e.g., if a company announces the launch of a new product or cutting-edge technology which looks promising, the investors will find it propitious and will prefer to buy shares of that company, hence shifting its demand curve to the right. On the other hand, if a company finds itself in legal issues or a law infringement case, it will produce a negative effect, and the demand curve will shift to the left.
2. Number of Buyers
If the number of buyers increases, the demand curve will shift to the right. This can be attributed to the increase in buying enthusiasm due to certain events. On the other hand, if the number of buyers decreases due to uncertainty or pessimism in the market sentiments, the demand curve will shift to the left.
3. Price of a related stock
A change in the price of a related stock will alter the demand in that stock depending on whether the stock is a substitute or a compliment.
a. Substitute stock
If two similar companies, A and B, offer shares to the public and if the share price of company B is overvalued as compared to A, then company A might look like an attractive investment. In this case, the demand for the stock of company A will increase. Also, if company B is losing revenue or is less efficient in terms of management than company A, the demand curve for company A will shift to the right, indicating a positive shift, whereas the demand curve for company B will shift to the left.
b. Complementary stock
If company C produces auto parts and company D produces vehicles, and if the demand for shares of company C rises, the demand for the shares of company D will rise as these companies operate in the same sector or are complementary to each other. This will shift the demand curves of both companies to the right. On the other hand, if the global markets are down due to a pandemic or any other important event, the demand for the stocks of companies belonging to that particularly affected sector will go down. This is called systemic risk. As a result, the demand curves for the affected stocks of these companies will shift to the left.
4. Income
This shifter is based on the amount the investors have at their disposal for investing or trading at a particular point in time. If the income of an investor rises, his/her trading capital is expected to rise as well. As a result, this will enable that investor to acquire more shares of stock. This will increase the demand, and as a result, the demand curve will shift to the right. If an investor incurs a loss and his/her trading capital is reduced; as a result, the number of shares he/she can acquire will reduce. This will shift the demand curve to the left.
5. Buyer Expectations
When the expectations of a trader or an investor change with respect to a particular company, this will shift the demand curve to the left or right. If the outlook is positive, the demand will rise, and the curve will shift towards the right, and if the outlook is negative, the investor will avoid investing in the stock of that company, and the demand curve will shift to the left.
Law of Supply
The law of supply establishes a direct relationship between the price and the quantity supplied. This law states that “ceteris paribus, if the price of a stock increases, the quantity supplied increases and if the price of a stock decreases, the quantity supplied decreases.” The quantity supplied is the quantity that sellers are willing and able to sell at a specific price at a specific point in time. Let us assume that an investor has bought 20 shares of a Stock X, which is trading at Rs. 250 per share. If the price of this Stock X rises to 500 per share, the investor would want to sell all the shares as this would entail more money. On the other hand, if the price falls down to Rs. 100 per share, the investor would want to sell fewer quantities of shares with the hope that the price will rise and he/she will be able to make a profit. Fig. 6 shows the supply curve for Stock X.
Change in Supply Curve
Every supply curve is defined by the supply schedule. Fig. 7(a) and 7(b) represent the old and new supply schedules of a Stock Y.
The supply schedules are plotted on the chart which is shown in Fig. 8
It is evident from the figure that the change in the values in the supply schedule shifts the supply curve either to the left or to the right. Here the supply curve shifts towards the right, giving a positive indication that the amount to be supplied has increased. Hence, any positive effect that increases the supply will shift the supply curve towards the right, and any negative effect that reduces the supply will shift the supply curve towards the left. These positive and negative effects are called supply shifters. Fig. 9(a) and (b) show the positive and negative supply shifts, respectively.
Supply Shifters
- Technology
Throughout most of our history, stock transactions were executed at physical locations or stock exchanges under the direction of a stockbroker. With the improvement of technology, telephones were put to use to assist in conducting stock transactions. Further developments in technology, like the advent of the internet and computers, made stock transactions considerably easier. Through these technological advancements, the cost of commission fees has been significantly reduced, and this has aided the growth of the number of shares being traded on the stock market. One could argue that technological developments have helped in increasing not only supply but also demand. When improvements are made in technology, this should reduce the cost for buyers and sellers, which would shift demand and supply curves to the right. On the other hand, if there is a technological setback, the supply diminishes, and the supply curve shifts to the left.
2. Price of other stock
If companies X and Y operate in the same industry and company X looks more promising due to certain policies or other financial factors than company Y, then there would be less selling activity in the stock of company X. This will shift the demand curve of shares of company X to the right and the supply curve to the left. Conversely, the supply curve for company Y will shift to the right (supply increases) due to fewer expectations of returns from the stock of company Y.
3. Number of sellers
Investors buy stock with an intention to sell the stock in the future to willing buyers. As buyers accumulate shares, the demand curve gets shifted to the right as more buyers demand stock. This is also symbolized as ‘greed’ in the market. If they decide to sell, then the supply is being dumped back onto the market, and so the supply curve shifts to the right, which is also symbolized as ‘fear’ in the market. Essentially as more sellers enter the market, there are more shares being supplied, and this will shift the supply curve to the right. When the number of suppliers or sellers decreases, the supply curve shifts towards the left.
4. Taxes
Some long-term investors favor stocks that offer higher dividend pay-outs, while others favor low dividend pay-outs, which are sometimes associated with taxes and tax benefits. Taxes play a minimal role in the trading decisions of small retail traders. Taxes can affect dividend policies for companies. Investors, however, will react to these policy changes by adjusting the number of shares being held, and depending on the policy change, the supply curve can shift to the left or to the right. If the change in company policy benefits the shareholder, the supply curve will shift to the left because current shareholders will hold on to their shares, so there would be a reduction in shares being sold. If the company policy had an adverse effect on shareholders, this would shift the supply curve to the right because shareholders would be selling their shares.
5. Seller Expectations
From the perspective of the seller, changes in future expectations will shift the supply curve to the left or right, depending upon the nature of expectations. If positive expectations prevail among the sellers, more and more sellers will hold on to their shares, and this will reduce the supply of shares in the market. This will shift the supply curve to the left. If negative expectations prevail among the sellers, they are more likely to dump shares on the market. This will shift the supply curve to the right.
Understanding the Market Equilibrium
When the quantity supplied is equal to the quantity demanded, the market is said to be in equilibrium. The price at which the market is said to be in equilibrium is called the market-clearing price. This can be formulated using the supply and demand curves. Fig. 10 shows the price vs. volume chart on a weekly basis.
It is evident from the chart that the quantity demanded equals quantity supplied at 600 shares trading at Rs. 3 per share. At this price, the market can be said to be balanced or in equilibrium. Now let’s consider two scenarios. In the first scenario, the company announces certain positive policy changes which create buying enthusiasm in the market. In the second scenario, the revenue of the company falls considerably, investors have negative expectations about the stock, and the number of sellers increases as a result.
In scenario 1, as the number of buyers increases, hence demand increases. As a result, the demand curve shifts to the right. The new demand curve intersects the supply curve at a new point. This is the new market equilibrium. The share price at the new equilibrium is approximately Rs. 3.75, which is Rs. 0.75 more than the old market-clearing price. This shows that the price of the stock increases when the demand curve shifts to the right. This is shown in Fig. 11(a). It is also evident that when the demand curve shifts to the left, the price of the stock must reduce.
In scenario 2, as the number of sellers increases, the supply curve must shift to the right. This positive supply shift creates a new equilibrium point. The price per share at this new equilibrium point is approximately Rs 2.25, which is Rs. 0.75 less than the old market-clearing price. Hence, the price of the stock decreases when the supply curve shifts to the right, and the price of the stock must increase if the supply curve shifts to the left. This is shown in Fig. 11(b)
This theory provides us with a basic understanding of the supply and demand in the stock market. It is assumed that during the demand and supply shifts, all other factors and parameters remain equal. This theory can be used to predict the price movement of stocks after certain events that might influence the buying or selling enthusiasm in the market.
