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Economics Posts [2] - A Simple Demand and Supply Model of Stock Market Prices


Contributed by one of the consultants to Sallyforth Enterprise

I was recently giving consultation to a client, when this thought came to my mind: "Everything in economics can basically be explained by supply and demand."

I actually said that to her, confidently, in the course of our consultation:

"Everything in economics can basically be explained by supply and demand."

The problem with that statement was that it was too simplistic; I needed to also take into account market failures, government failures, and the structure of the industry, as well as moral, societal, philosophical, political considerations, and a whole bunch of other things. Well, to put it another way, I do know my economics well enough to be invited to write an article for this famous economics blog by my good friend.

But I was just trying to illustrate a point - that at its core, the market basically works on demand and supply (and a whole bunch of other things, too, ceteris paribus).

In this economics post, I want to share some insights from economics on the stock market.

Not on what I want society to be, like Ryan talked about - but on stock prices and how demand and supply can help in our analysis of market prices.

This means that, basically, my post is about a simple demand and supply model of stock market  prices.

Armed with this incredible illuminating or incredibly unexciting model, you will be ready to become a stock market millionaire. That is how great my economics post will be.

Just kidding.

This is just my contribution on economics: some ideas off the top of my head.

I should emphasise that this is just an academic model, and no advice on stocks, finance, investment, and making money is given here. That is a profession in its own right (or is it really?) and that is a question for another time. I am just talking here about a simple demand and supply model of stock market prices.

OK enough rambling. Let's begin.

I think that prices in stock markets are determined by the intersection of the demand and supply curves for a particular stock, in the stock market, ceteris paribus.  

Yawn.

I said that already, didn't I?

I think, the real question is: what are the determinants of demand and supply that affect a particular company's shares, in the stock market, assuming no market failures, ceteris paribus?

Now, this is what we are really discussing:

Demand Factors

First would be income. 

A rising income (household income or national income would be great proxy indicators) would raise the demand for any stock, as people seek to place their savings somewhere.

Second would be the stock's EPS (earnings per share).

The higher the EPS, the more likely the company would be profitable, and over here in my economic model the predominant assumption is that rational, profit-maximising people want to invest in profitable companies. Therefore, a rising EPS would lead to a rising demand for that company's stock.

Third would be the dividend rate.

The higher the dividend rate, the more money shareholders get when it comes to distribution time. Therefore, it stands to reason that a rising dividend rate would shift the demand curve for a particular company's stock to the right, raising prices, ceteris paribus.

Fourth would be the tastes and preferences for a particular investment theme.

If there is a theme that is particularly popular in recent moths, then there should be an increased demand for companies that are in that industry. Healthcare becoming a major issue in recent months? A new craze in town, or new thirst for the oil and gas industry? Bob's your uncle!
There are also other demand factors, but as an intellectual exercise, I will let you figure out what they are. Think about population and demographics; advertising and persuasion; and a whole bunch of other things like complements and substitutes.

Supply Factors

Other than demand, there is also the issue of supply.

First would be the number of shares. 

If there is a share consolidation, then the number of shares are reduced, and the supply would fall - no surprises here. If there is an increase in rights shares, then the supply would increase (or be perceived to increase), and the supply would increase.

Second would be what I call government intervention, or in this case, the "SGX intervention" or "MAS intervention". 

Trading halts, suspensions, and new SGX rules (the infamous and rather ridiculous MTP - Minimum Trading Price rule - comes to mind) would impact the supply of a particular company's stock.

There are also other supply factors, but as an intellectual exercise, I will let you figure out what they are. Do think about things like inputs, factors of production, and clearly in Singapore's case things like international trade.

Conclusions?

In the final analysis, stock prices really depend on a multitude of factors but a simple demand and supply model can help clarify one's thinking. This shows that supply and demand really form the bedrock of economics - and this is a crucial insight. If we could further incorporate market failures such as imperfect information and asymmetric information into this economic model, I think it would be a more robust and stronger model.

Now, are you ready to become a stock market millionaire? :)

*** ***

JC Economics Essays - Special thanks to S for this excellent contribution on a simple model of stock market prices. This essay is part of a series on economics posts shared by friends and readers on a range of economic issues or themes that interest them. It is a brief and hopefully illuminating diversion from my usual focus on purely A level economics essays.

After a quick run of economics posts on various socio-economic, political, and every day themes, I will do some quick data analytics on the results and crunch some numbers on the interest and readership - and then I will resume posting relevant, useful, and well-written model economics essays for H1, H2, and H3 A levels economics examinations. (This is as I always do - to help students through reading and learning from economics essays.) In the meantime, however, hopefully, these essay contributions can expand readers' thinking and inspire them to understand the beauty of this subject. 

I sincerely hope these economics posts on a range of topics beyond pure examinations can do something positive.

Thank you for reading, and cheers.

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