For most of us the entire financial market system represents a great and complex puzzle. We often hear of prices, bubbles, supply and demand, but don’t actually know what it’s all about.
Supply And Demand: Easier Than It Looks
The underlying mechanism is the same for any market: it is the combination of supply and demand. Where demand is “the set of goods and services that people are willing to buy” and supply is “the set of goods and services that people are willing to sell”.
The market is the union of all sellers (be they people, subjects or companies) and all buyers. Those who buy will look for the lowest price, those who sell will look for the highest price: the combination of supply and demand determines the price of a good or a service.
The Supply and Demand Levers
The stimulus of supply and demand has a very simple consequence: the more demand there is, the higher the price, because more people need that good or service. The greater the supply, the lower the price.
Let’s say we are wine connoisseurs: we would be willing to pay higher prices for rare bottles or fine years, precisely because there are few of them (supply is low) and demand is very high. On the other hand, the “classic” ones will have a much lower cost, because banally there are many more and they are easily available since more subjects sell them.
Read more about the supply and demand levers in the article “Cryptocurrency: What are Altcoins?“.
What Affects Demand?
However, this mechanism is not “mathematical” because other forces, internal and external, that can influence the market come into play.
- These include consumer preferences: between two bottles of equally-priced wine, I will buy the one I consider the best or the highest quality.
- Another factor may be the development of complementary goods, such as sugar and coffee or petrol and cars. If the price of petrol rises too much, the purchase of cars falls.
- Finally, market expectations come into play when I expect the price of the product to cost more or less tomorrow. If, for example, I know that this year’s hail has ruined the whole Franciacorta grape harvest, I can expect bottle prices for this vintage to rise and therefore decide to buy a batch today instead of a few years from now.
What Affects Supply?
The main factors that affect the availability of a good or service and thus the supply are:
- Technological innovation,
- production costs
- government incentives
Let’s mention an actual case. The new tax credit for 2020 contributes to 40% of the investments and up to 2,5 million euros for agricultural machinery with 4.0 technology. In this case, both technological innovation and government incentives are involved. Combined they may lead to lower production costs and thus to lower prices for certain agricultural products.
The Financial Markets
Since economics and finance revolve around the concept of the market, and it is in the market that we invest, it is essential to understand how it works.
There are, in fact, a myriad of markets, literally for everything you can buy or sell: food, clothes, wine, figurines, games, football players, etc..
Markets for financial instruments are called “financial markets“, where shares, bonds, government bonds and much more are traded. By buying one or more of these instruments you invest in their growth, with the aim of obtaining a return. So the investment is nothing more than an expense made today to generate a profit tomorrow.