Supply Demand

Overview

To understand how supply and demand affect price and volume, it is useful to think of the buyers and sellers of an item as separate groups. For the purposes of this discussion, we leave the item in question to be unspecified. The principles enumerated here are the same no matter what the item is, if its a product or an asset such as an equity (stock).

The buyers of the item all have a reservation price, that is, a price where the buyer is indifferent between buying or not buying the item in question. At a price below the reservation price, the buyer is made better off by the trade, at a price above the reservation price, the buyer is made worse off.

It is important to note that buyers will have different reservation prices, depending on how much they value the item in question. In fact, we could hypothesize that there is some distribution of reservation prices among the buyers.

Here we plot a hypothetical distribution of the number of buyers who have a reservation price at a set of given prices (prices on the x axis, number of buyers with that reservation price on the y axis)

It is important that the distribution above does not graph the number of buyers at any price. The graph is the graph of reservation prices. As such, a buyer is willing to buy at any price at or below their reservation price. Technically speaking, this is computed using an integral



The sellers are on the flip side of the coin to the buyers. Sellers also have a reservation price, the price above which it is in their interest to transact, below which it does not make sense to transact.

A sellers reservation price for a manufactured good is tied very directly to that sellers ability to produce the good. Businesses need to cover the cost of acquiring a good (either through production, or through purchase) and any other expenses associated with that good, plus they need a certain amount of return in order to be profitable.

Standard micro-economics would suggest that for a large market, all sellers would have the same reservation price, that is the price for which sale of the good in question yields zero economic profit. While useful in theory, the reality is that the sellers will have a distribution, much like the buyers.

For goods that are not standard manufactured goods, the analysis is similar. For example, if the item in question is an equity asset (such as a stock), then the distribution of reservation prices reflects the buyers and sellers belief in the fair price of the asset.

The chart of the number of sellers at any price will be the reverse of the chart of the buyers. That is, a seller will transact at any price over their reservation price (not below)





The intersection of the two curves reprsents the price level and volume that is being transacted. This graph helps us think what causes the price or volume to move. In particular, there are several changes to the supply demand curves that could cause a shift in price and/or volume

• the curves could move closer together. THat is, when there is a converging opinion between buyers and sellers, one or both curves move toward each other. This may cause the price to move (depending on whcih curve moves and by how much) , but it definitely causes the volume to go up.
• the curves move apart : in which case there is a divergence of opinion on the price and the volumen goes down
• the width of the curve tightens: if either the buyers or sellers start to converge toward their mean, this will cause the curve to crunch together

Demonstration

negotiation

Note that the market price will be the point on the x-axis where the two bottom (accumulation) curves cross, and the volume transacted will be the value of the y-axis at the point of crossover.

This type of model can go a long ways to explaining how price and volume change. It is probably most relevant in assessing the price and volume of trades on the stock market. It can be used to explain how it is possible that the price could move, but volume goes down. Or how volume could go up, but price remains constant.

Liquidity

Liquidity is the ability of trader to easily buy or sell a security, without moving the price significantly in the process. Liquid assets can be turned into cash quickly and easily.

Liquidity can best be understood as the size of the desired trade, relative to the demand curve for that security. If the size of the trade is large versus the amount of demand for a security, then the security would be relatively illiquid. In addition, if the demand distribution (seen above as a bell curve) is relatively flat and spread out, that would indicate that amny trade of a certain size will have a large price impact.