Supply and Demand

Supply and Demand is the foundational concept of economics, describing the dynamic relationship between the availability of an asset or service and the desire for it. Think of it as the ultimate market tug-of-war. Supply represents how much of something is available—be it barrels of oil, newly built houses, or shares in a company. Demand represents how much of that thing people want to buy. The constant interaction between these two forces determines the price of virtually everything in a market economy. This elegant mechanism, which the famous economist Adam Smith referred to as an “invisible hand,” guides resources to their most valued uses without any central planner. For an investor, understanding how supply and demand affect asset prices is not just academic; it's the key to understanding why market prices move and how to find opportunities.

At its heart, the concept is a beautiful balance of two opposing forces. Let's break them down.

Supply is the total quantity of a specific good or service that a seller is willing and able to provide to the marketplace at a given price. The general rule here is called the Law of Supply: all else being equal, as the price of an item increases, suppliers will attempt to maximize their profits by increasing the quantity they offer for sale.

• Example: Imagine you're a toymaker. If your new action figure sells for €10, you might produce 1,000 units. But if a sudden craze drives the market price up to €30, you'll likely run your factories overtime to produce 5,000 units and cash in on the higher price. Conversely, if the price collapses to €2, you might halt production altogether.

Demand is the quantity of a good or service that consumers are willing and able to purchase at various prices during a given period. The counterpart to the law of supply is the Law of Demand: all else being equal, as the price of an item increases, the quantity demanded will fall.

• Example: At $200, you might eagerly buy the latest video game console. But if the price were $800, you'd probably think twice and might opt for a cheaper alternative or simply wait. If the price dropped to a bargain $50, you might even buy one for yourself and another as a gift.

So, if sellers want high prices and buyers want low prices, how is a final price ever decided? They meet at a point called equilibrium. The equilibrium price (also known as the market-clearing price) is the price at which the quantity supplied is equal to the quantity demanded. On a chart, this is the magical point where the supply and demand curves intersect. At this price:

• There is no shortage of the item (buyers find what they want).
• There is no surplus of the item (sellers sell all their stock).

If the price is set too high, a surplus occurs because sellers offer more than buyers are willing to purchase. This forces sellers to lower prices to clear their inventory. If the price is too low, a shortage occurs as demand outstrips supply, allowing sellers to raise prices. This constant adjustment is what pushes the market price toward equilibrium.

This simple principle is a powerful force in financial markets, especially for stocks.

A company's stock is subject to the same laws of supply and demand.

• Supply of Stocks: The supply is the number of shares a company has issued, known as shares outstanding. This number is relatively fixed but can change. For instance, a stock buyback reduces the supply of shares, which can help push the price up. Conversely, a secondary offering increases the supply, which can dilute existing shareholders and put downward pressure on the price.
• Demand for Stocks: Demand is driven by what investors think a company is worth. This is influenced by many factors: strong earnings per share reports, positive news, innovative products, or broad economic optimism. When good news hits, more people want to buy the stock than sell it (demand > supply), and the price is bid up. When bad news breaks, more people want to sell than buy (supply > demand), and the price falls.

Here's where a savvy investor gains an edge. While short-term price swings are driven by the frantic dance of supply and demand, a value investor plays a different game. They believe that the market often gets it wrong. This is where Benjamin Graham's brilliant allegory of Mr. Market comes in. Mr. Market is your emotional business partner who offers to buy your shares or sell you his every day. Some days he is euphoric and names a ridiculously high price (high demand). On other days, he is panicked and offers to sell his shares for a pittance (low demand). A value investor doesn't get caught up in Mr. Market's moods. Instead, they first calculate a company's intrinsic value—what it's truly worth based on its assets, earnings power, and future prospects. Then, they use the market's emotional swings to their advantage:

• They buy when irrational fear creates low demand, causing Mr. Market to offer a price far below the company's intrinsic value. This gap between the low price and the higher intrinsic value is the famous margin of safety.
• They ignore or sell when irrational exuberance creates high demand, pushing prices far above what the business is fundamentally worth.

In short, a value investor uses the often-irrational fluctuations of supply and demand to buy wonderful businesses at a discount.