What do supply and demand mean: An investor’s understanding

When investors look at asset prices in the market, they are seeing the results of two forces that determine those prices: demand and supply. Demand and supply refer to the desire to buy and the desire to sell that occur in the market. These two forces are key to understanding how prices move and change. This concept is not only fundamental to economics but also a powerful tool for investors to forecast future price directions.

Definition: What Are Demand and Supply?

To clearly understand this concept, we need to discuss each side separately. Imagine you enter a market and see a product. One side consists of people who want to buy (buyers), and the other side consists of people who want to sell (sellers). The interaction between these two parties creates the price.

Demand refers to the desire to purchase goods or services at various price levels. On a chart, we see the demand curve, which reflects the relationship between price and the quantity consumers are willing to buy. Each point on this curve indicates how many buyers are willing to purchase at a certain price and in what quantity. It also shows the maximum price consumers are willing to pay for a given quantity.

Supply refers to the willingness to sell goods or services at various price levels. The supply curve illustrates the relationship between price and the quantity sellers are willing to offer. Each point on this curve indicates how much sellers are willing to sell at a certain price and shows the minimum price they are willing to accept for a given quantity.

Basic Law: The Relationship Between Price and Quantity

The Law of Demand: How Buyers Behave

As the price increases, the quantity demanded decreases. Conversely, when the price drops, demand increases. This phenomenon is not accidental but results from how price changes affect demand in two ways:

Income Effect: When prices fall, the purchasing power of your money increases because you spend less to buy the same goods. This allows you to buy more of other goods.

Substitution Effect: When the price of a product decreases, it becomes a more attractive option compared to other products. People tend to buy this cheaper product instead.

The Law of Supply: How Sellers Respond

Sellers behave oppositely. When prices rise, they are willing to supply more because they can make higher profits. When prices fall, they are less willing to sell or will reduce the quantity offered because profits decrease.

Market Equilibrium: The Price That Settles the Market

Demand and supply curves are just concepts until they intersect. The point where they meet is called equilibrium. This is where the actual market price and quantity traded are established.

Why does the price tend to stay at this point? Because if the price is above equilibrium, sellers want to sell more, but buyers want to buy less, leading to excess supply and downward pressure on price. Conversely, if the price is below equilibrium, buyers want to buy more, but sellers are unwilling to sell enough, leading to shortages and upward pressure on price. These forces push the price back toward equilibrium.

Factors Driving Demand and Supply

Demand Is Not Only Price-Dependent

Besides price, demand also depends on:

• Income and economic conditions: Higher income generally increases demand.
• Preferences and trends: Some people prefer certain products over others.
• Number of buyers: More buyers mean higher demand.
• Prices of related goods: If substitutes become cheaper, demand for the original product decreases.
• Expectations: If buyers expect prices to rise in the future, they may buy more now.

Supply Depends on Costs and Production Conditions

Producers consider:

• Production costs: Higher costs discourage supply.
• Technology: Improved technology reduces costs, increasing supply.
• Prices of alternative products: If producers can make more profitable products, they may shift supply.
• Number of producers: More producers lead to higher supply.
• Expectations: If producers expect prices to fall, they may sell more now.

Application in Financial Markets

In stock and financial markets, demand and supply factors are more complex than in typical goods markets.

Demand Drivers in Financial Markets

• Macroeconomic conditions: Low interest rates encourage investment in stocks.
• Market liquidity and money supply: More money in the system means more investment.
• Investor confidence: Optimism about the future increases buying; fear leads to selling.

Supply Drivers in Financial Markets

• Corporate policies: Issuing new shares increases supply; buybacks reduce it.
• Initial Public Offerings (IPOs): New companies entering the market add to supply.
• Regulations: Restrictions on large shareholders selling can reduce supply.

Advanced Trading Technique: Demand Supply Zone

Modern traders have developed methods using demand and supply to make trading decisions called Demand Supply Zones, which analyze price trends to identify turning points.

Reversal Patterns: Trend Reversal Points

Demand Zone Drop-Base-Rally (DBR): Begins when heavy selling pushes prices sharply down (Drop), followed by a period of consolidation (Base). When buying pressure returns strongly, prices break support and reverse upward (Rally). Traders can buy at this breakout point.

Supply Zone Rally-Base-Drop (RBD): The opposite: prices rise quickly due to strong buying (Rally), then consolidate (Base). When selling pressure resumes, prices break resistance and fall (Drop). Traders can sell at this breakdown point.

Continuation Patterns: Trend Continues

Demand Zone Rally-Base-Rally (RBR): When buying remains strong, prices rise, pause, then continue upward, indicating the uptrend is still intact.

Supply Zone Drop-Base-Drop (DBD): When selling remains strong, prices fall, pause, then continue downward, indicating the downtrend persists.

Traders use these Demand and Supply Zones to identify good entry points and set risk management levels.

Summary

Demand and supply refer to the fundamental desires of buyers and sellers in the market. These forces determine prices. Economists analyze them to understand markets; investors use them to select stocks; traders use them to time entries and exits. The only effective way to deeply understand demand and supply is to study real market examples and observe how these concepts manifest in actual asset prices.