Stock Equilibrium: What role does supply and demand play in driving stock returns?

Tuesday, Aug 10 2010 by
Stock Equilibrium What role does supply and demand play in driving stock returns

One of the oldest saws in the book of economics is the idea of supply and demand; it even pre-dates Adam Smith, with a legacy stretching back to Muslim thinkers of the eleventh century. If people demand the Pet Rock as the next must-have toy but supply is limited then prices of Pet Rocks will go up. If some enterprising rock counterfeiter then floods the market with a supply of good-enough fakes then the demand is likely to fall, and price with it. This iron rule of economics is actually a bit less rigid than you might think. In fact, it's rather too wibbly-wobbly to describe it as a rule at all. But at the margins it more or less works which means it's rather curious that it's rarely cited as a reason for long-term changes in stock prices. It stands to reason, though, that if lots of people decide they want to buy shares just as companies start to withdraw them from the market that prices should go down. Or does it?

Partial Equilibrium

Supply-demand models are based on so-called partial equilibrium, the idea being that you can look at the market for some goods or other independently of all other variables. This certainly can't be true most of the time – it's like working out what the correct price is for lighters without taking into account the availability of matches. Or Boy Scouts with a handy supply of dry sticks and kindling.

Linked to this is the concept of elasticity. If the quantity demanded changes a lot when there's only a small change in price then it's elastic. If the quantity demanded changes little when prices change a lot then it's inelastic. So the market for bread tends to be inelastic because changing the price of it doesn't markedly change the amount consumed. As you might have twigged, many economic theories of the stockmarket assume that stocks are inelastic . If this wasn't the case then stuff like the Efficient Markets Hypothesis wouldn't be even vaguely possible.

Pareto Groping

Now the idea that markets are efficient and prices reflect all known information somewhat begs the question about how this occurs. This rather fundamental problem has perplexed generations of economists who've come up with a concept to explain it known as tâtonnement which, joyously, translates as "groping" or, as non-economists say, "trial and…

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About timarr


I'm a UK based technologist (career) and psychologist (academic) with a long-term interest in financial markets, with a particular emphasis (and skill) in how to not make money out of them. When I'm not working or blogging I'm to be found childminding, walking the dog or hiding in the garden shed with a good book :) more »

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