Supply and Demand Theory and Economic Cycle

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1 Supply and Demand Theory and Economic Cycle Introduction The basic supply and demand theory is vital for understanding investments A simple illustration of the supply and demand for oil with graphical representation is used to help you understand We will discuss the stages of economic cycle, followed by evaluating the industry and product life cycle

2 Introduction to Supply and Demand Theory In order to understand what is investment and how it works, you will need a basic understanding of economic theory of supply and demand In any country, demand for goods and services is the fundamental reason for economic activity The supply side activity in the economy fulfils that demand by making the goods and services available Aggregate supply of a product represents the total supply available from suppliers Aggregate demand represents the total demand sought by buyers at different price levels for the same product Aggregate Demand for Goods and Services Let us illustrate a simple demand situation for a commodity such as oil The table below shows the quantity (in number of barrels) that is demanded based on different price levels (in $ per barrel) Price of oil per barrel $ 80 $ 60 $50 $ 40 $ 20 Demand in no. of barrels 20,000 40,000 50,000 60,000 80,000 You will notice that when the price of oil gets cheaper, more quantity of oil will be demanded by consumers At higher prices, fewer buyers are willing to pay the price. Hence the demand is lower As prices become cheaper and more affordable, demand increases Such a relationship between price and quantity demanded is said to be inverse

3 Aggregate Supply of Goods and Services On the other hand, at the supply side, more and more of the quantity will be made available by suppliers each time the price gets higher This is because suppliers whose costs are higher will now be willing to release more of the commodity into the market as they will be able to profit from the higher prices Such a relationship between supply quantity and price is said to be direct The table below shows the different supply quantities at different price levels Price of oil per barrel $ 20 $40 $50 $60 $80 Supply in no. of barrels 20,000 40,000 50,000 60,000 80,000 Aggregate Supply and Aggregate Demand In 1 Single Chart We can now combine the two tables above showing the aggregate demand and aggregate supply of oil by using a simple graph as shown below. The vertical Y-axis shows different price levels and the horizontal X-axis represents quantity in barrels: $90 $80 $70 $60 $50 $40 $30 $20 $10 $0 Price of Oil per barrel 20,000 40,000 50,000 60,000 80,000 SUPPLY DEMAND

4 Concept of Equilibrium Pricing Equilibrium pricing is achieved when the exact quantity of demand meets the exact quantity of supply This happens when the maximum number of buyers willing to buy at that price matches that of the quantity supplied In the illustration above, the equilibrium price of $50 per barrel is achieved when the quantity of 50,000 barrels demanded is met by the available supply Just as for goods and services, prices for all securities can be similarly analysed using the supply and demand theory at a very basic level. Factors Affecting Supply and Demand Some factors affecting aggregate supply of a product Physical constraints that limit its availability Time lag in production process Technological changes that rapidly affect supply Changes in government policies that influence supply Some factors affecting aggregate demand for a product Stage of economic cycle and level of business activity Income level, especially disposable income, of the population Availability of substitute product or service Cyclical and seasonal demand for some products or services

5 Assumptions of Supply and Demand Theory In order for the supply and demand theory to work perfectly, here are some of the assumptions: The market place is perfect with information readily available for all The product or service demanded and supplied is homogenous, of the same type or quality which cannot be differentiated There is perfect competition without any government or other unfair interventions or regulations All market participants act and behave rationally when buying or selling Economic Cycle, Industry and Product Life Cycles Stock prices tend to rise when the economy does well and to fall when the economy is weak Hence the need to understand the state of the economy when investing The economy itself is subject to changes that often come in different stages in a cycle of business activities ranging from DECLINE to RECOVERY to GROWTH to MATURITY. We will next look into how industry life cycle as well as product life cycle changes affect investmentmaking decisions

6 Economic Cycle and Impact on Investing An economy will often grow unevenly and undergo different stages and levels of business activity. This is due mainly to: The physical constraints of increasing supply and demand The time lag effects of production and demand on economic activity Economic Cycle and Impact on Investing The 4 stages of economic activity in a typical economic cycle are: high unemployment rates begin to drop as more jobs are created, investment activity picks up steadily this is the recession stage with high unemployment, reduced business investments and consumer spending due to a lack of confidence boom or expansion phase as recovery gathers full steam with high employment and concerns over rising prices growth in economy tapers off as boom can no longer be sustained due to supply constraints and government measures to contain inflation in growth stage

7 Economic Life Cycle A Graphical Representation Graphically the 4 distinct stages of an economic cycle can be shown below: Level of economic activity GROWTH MATURITY DECLINE RECOVERY Time Impact of Industry and Product Life Cycle on Investment Decisions Just like the economy, most industries and products too will undergo life cycle stages peculiar to themselves As an illustration, historically the shipping industry is well-known for going through stages of boom and bust. During good economic times, newer and bigger ships are often commissioned and built due to optimistic projections and availability of financing for ship construction. By the time the new ships are ready for service, the economic conditions have turned for the worse, resulting in overcapacity and drop in shipping rates. Products, too will undergo life cycle stages from PRODUCT INTRODUCTION to GROWTH to MATURITY to DECLINE. Hence the importance of industry and product life cycle analysis when considering investing

8 Summary An illustration of oil dynamics to understand the simple workings of the supply and demand theory The factors affecting supply and demand, and the various assumptions associated with the theory The 4 different stages of the economic cycle How industry and product life cycles can impact the investment decision-making process References Gitman, Joehnkand Smart, Fundamentals of Investing, 2011 Chapter 1 The Investment Environment Chapter 7 Analysing Common Stocks Websites :