Supply, Demand, and Price Formation

Before you can understand stocks, bonds, or derivatives, you need to understand how prices are determined in any market. It starts with supply and demand.

The Law of Demand

People buy less of something when its price goes up, all else equal. This is demand.

Demand curve: A downward-sloping line showing how much quantity people will buy at each price. Move right along the curve (lower price → more quantity demanded).

Shifts in demand: When income changes, tastes change, or expectations change, the entire curve shifts:

• Right shift = more demanded at every price (demand increases)
• Left shift = less demanded at every price (demand decreases)

The Law of Supply

Producers supply more of something when its price goes up, all else equal. This is supply.

Supply curve: An upward-sloping line showing how much quantity producers will sell at each price. Higher price → more supplied.

Shifts in supply: When costs change, technology changes, or expectations change, the entire curve shifts.

Market Equilibrium

The price where supply equals demand is the equilibrium price: the market-clearing price. At this price:

• All goods produced are sold
• All consumers who want to buy at that price can buy
• No tendency for price to change

Shortage (excess demand): When price is below equilibrium, quantity demanded exceeds quantity supplied. Buyers compete → price is pushed up.

Surplus (excess supply): When price is above equilibrium, quantity supplied exceeds quantity demanded. Sellers compete → price is pushed down.

Why Prices Matter

Price is the market’s way of aggregating information. In a well-functioning market, price reflects:

• How scarce something is
• How much people value it
• How costly it is to produce

This is why prices are so important in finance. A stock price is the market’s assessment of a company’s value. A bond yield is the market’s assessment of credit risk and interest rate expectations.

Market Price Discovery

Prices don’t exist before trades happen. The process of finding the right price is called price discovery.

In financial markets:

• Buyers submit bids (maximum prices they’re willing to pay)
• Sellers submit asks (minimum prices they’re willing to accept)
• When bid ≥ ask, a trade happens at some price in between

This is why financial markets have a bid-ask spread: the gap between the highest bid and lowest ask. The spread represents the cost of immediate trading.

Supply and Demand in Financial Markets

In financial markets, supply and demand have special characteristics:

Substitutes: Financial assets have close substitutes. If Microsoft stock is “cheap” relative to similar tech stocks, investors will buy Microsoft and sell the alternatives, restoring equilibrium quickly.

Expectations drive demand: People buy financial assets partly because they expect prices to rise. This creates feedback loops: rising prices attract buyers, which pushes prices higher still.

Leverage amplifies swings: Financial markets allow borrowing to buy assets. This amplifies both demand surges and selling waves.

Key Takeaways

• Prices form where supply meets demand
• Prices convey information about scarcity, value, and cost
• In financial markets, prices reflect collective expectations about the future
• Deviations from equilibrium create forces that push prices back (but markets can stay irrational longer than you’d expect)

References

• Mankiw, Principles of Economics, Ch. 4-6. Cengage, 2017. ISBN: 978-1-305-97177-9.
• Kremer, “Markets.” Introduction to Economics, Ch. 3.