How the world works from my point of view

No concept has made me understand more about the world in recent memory than the concept of demand and supply. It took me some time, but once I begin to grasp the concept, it opened my mind to a whole new way of looking at things. You might not notice, but once you really start to think about it, many things in the world can be explained by demand and supply. Don't believe?

1) Why are some items so expensive and others so cheap? If you think about it, it is demand and supply. Take the extreme case. Air is free because it is supposedly unlimited. Salt is cheap because supply is plentiful. Ferraris are expensive because demand is high and supply is low. This could go on forever but you get the idea.

2) Demand for LSE degrees are high and supply of classrooms is low. As a result, 60+ people have to squeeze into a classroom for 40 people. And this is not the first time happening already. This is evident in other modules too. All these when we pay exhorbitant school fees, and the reason why LSE can do so is because demand for LSE degrees are high...

3) Doing my own investments in stocks made me appreciate the concept even more. Technically speaking, the price of a stock at a moment in time is the concensus price that all buyers are willing to pay (demand) and all sellers are willing to sell for (supply). What causes the demand/supply to change? Many reasons. I would like to say that I am a fundamentalist at heart, but ultimately, demand and supply has helped in my understanding and acceptance of technical analysis. I believe that what ultimately drives share prices in the long run is profits, but in the short run, there are many other factors to consider. Human nature dictates that we are self-maximising individuals i.e. we are greedy and want to make as much profits as possible. As companies report higher and higher earnings, investos flock to buy the stock to participate in the growth. This increase in demand pushes up prices. As prices increases, more investors flock in, triggering a vicious cycle known as a bubble. This scenario occurs when stock prices are no longer explained by fundamentals as seen in the tech bubble. Ultimately, prices drop and fear set in. Investors look to unload stocks, increasing supply dramatically. But with low demand for stocks due to fear, prices plunge and this continues and result in what we call a stock market crash. This is why stock markets goes in cycles.

4) The recent hoohah about the subprime mortgage crisis is also intrisically linked to demand and supply. As cheap money flooded the world, people demands rise as they can borrow more at cheap rates. Part of this supply of money is spent on housing, and as demand for them increases, the prices of houses increases. More construction took place to increase the supply to take advantage of the increase in demand. Similarly, as more people turned to property, the demand for mortgages increases. Mortgage standards are relaxed so that they can earn more $$, with the impression that the insatiable demand for housing will result in continued increased in house prices. Creative ways are then used aka financial innovation to securities these mortgage loans into CMBS that are rated highly by rating agencies before being sold off by banks to investors who are given the false impression that they are investing in safe instruments with high returns. As people feel richer, they invest their money in a 2nd property and the vicious cycle continues. All parties seem to benefit from this cycle of events. More people get to own a home that increase in prices, the mortgage lenders, rating agencies and banks make lots of commission and the investors earn high returns for taking on AAA CMBS. Sounds too good to be true? Indeed all these were brought to an abrupt end when people started defaulting on their loans which triggered another chain of events which I shall not go into detail here. Again, this is why economies goes in cycle too.

Even now, I can list many examples of the concept of demand and supply at work. One notable example is the automobile industry. With the increase in oil prices caused by skyrocketing demand and tight supply, the turn to alternative fuels as a solution suddenly gains much prominence. This increased demand by consumers lead companies to spend more money on R&D to develop new technology e.g. hybrids, ethanol, diesel to power our vehicles. I am sure that in a few years time, with sustained increase in oil prices, new technology economical for commercialization will surface and consumers will experience a drastic changes in the way we commute.

Ultimately, it all boils down to concept of demand and supply. But if you look deeper, it is also closely linked with human nature. In economics 101, we learn that humans have unlimited wants in a world of limited resources. We also learn that all individuals are self maximising i.e. greedy by nature. It is precisely these assumptions, coupled with the fact that humans adapt to changes in the environment that make the concept of demand and supply such a powerful force that can explain so many things happening around the world.

I hope that this has been an educational read. The concept of demand and supply has opened my eyes, I hope it will do the same for you too.