Supply and Demand

The law of supply states that the quantity supplied of any good or asset increases as its price rises — all other factors held constant — because higher prices make production and sale more profitable, attracting additional supply. 

The intersection of the demand curve and the supply curve determines the equilibrium price — the only price at which the quantity buyers want to purchase exactly equals the quantity sellers want to supply — and the equilibrium quantity simultaneously exchanged. 

Supply and demand is the most fundamental analytical framework in all of economics and is directly tested on the Series 65 examination in the context of how markets determine prices, how shifts in supply and demand affect equilibrium, and how these principles apply specifically to financial markets including the market for securities, the credit market, and the market for currencies.

The Law of Demand — The Inverse Price-Quantity Relationship

The law of demand states that there is an inverse relationship between the price of a good or asset and the quantity demanded — when price rises, quantity demanded falls, and when price falls, quantity demanded rises, all else being equal.

The ceteris paribus condition — Latin for all else being equal — is essential to the law of demand. The inverse price-quantity relationship holds only when all other factors affecting demand remain constant. When those other factors change — when consumer incomes rise, when the prices of substitute goods change, when consumer preferences shift — the entire demand curve shifts, changing the quantity demanded at every price level rather than simply producing a movement along the existing curve.

The demand curve plots this inverse relationship graphically — price is measured on the vertical axis and quantity is measured on the horizontal axis, and the demand curve slopes downward from left to right, reflecting the law of demand. At any given price, the demand curve shows how much buyers are willing and able to purchase. As the price falls, the demand curve shows that buyers are willing and able to purchase more — they move down and to the right along the curve to a higher quantity demanded at the lower price.

Two economic mechanisms explain why demand curves slope downward. 

The substitution effect describes how consumers switch to alternative goods when a specific good's price rises — if the price of beef rises substantially, consumers substitute chicken, pork, or other proteins, reducing the quantity of beef demanded. In financial markets, the substitution effect operates through the competition among financial assets — when bond yields fall, investors substitute equities for bonds because equities offer higher expected returns, reducing demand for bonds and increasing demand for stocks. 

The income effect describes how a price change affects the real purchasing power of consumers' fixed incomes — when the price of a good falls, consumers can purchase more of it with the same nominal income, effectively becoming wealthier in real terms and therefore demanding more.

The Law of Supply — The Direct Price-Quantity Relationship

The law of supply states that there is a direct — positive — relationship between the price of a good or asset and the quantity supplied — when price rises, quantity supplied increases, and when price falls, quantity supplied decreases, all else being equal.

The supply curve plots this direct relationship graphically — sloping upward from left to right, reflecting the law of supply. At higher prices, producers are willing and able to supply more because higher prices generate higher profit margins that justify the additional costs of expanding production, and because higher prices attract new entrants who were previously unwilling to produce at lower price levels.

In financial markets, the law of supply operates differently than in goods markets because financial assets are not physically produced in the same sense as manufactured goods. 

The supply of a company's shares is fixed in the short term — the company has a specific number of outstanding shares that can only be increased through new equity issuances. However, supply in the financial market context also encompasses the willingness of existing holders to sell — at higher prices, more existing shareholders are willing to sell their holdings, effectively increasing the quantity supplied in the secondary market. 

This is why secondary market prices are determined by the interaction of buyers willing to purchase at various prices and sellers willing to deliver shares at various prices — the market-clearing price is the one at which the quantity that buyers want to purchase equals the quantity that sellers want to deliver.

Market Equilibrium — Where Supply Meets Demand

Market equilibrium is the price at which the quantity demanded equals the quantity supplied — the price that clears the market by precisely balancing the desires of buyers and sellers. At the equilibrium price, every buyer who is willing to pay the equilibrium price or more finds a seller, and every seller who is willing to accept the equilibrium price or less finds a buyer. There is no unsatisfied demand from buyers who want to buy at the equilibrium price and cannot find a willing seller, and no unsatisfied supply from sellers who want to sell at the equilibrium price and cannot find a willing buyer.

The self-correcting mechanism of competitive markets is one of the most important concepts in economics — markets tend toward equilibrium because price signals coordinate the behaviour of buyers and sellers in response to imbalances.

When the actual market price exceeds the equilibrium price, the quantity supplied at that price exceeds the quantity demanded — a surplus exists. Sellers who cannot find buyers at the high price are motivated to reduce their asking price to attract buyers. As prices fall, quantity demanded increases and quantity supplied decreases, narrowing the surplus until the price returns to equilibrium. In financial markets, this mechanism operates through competitive bidding — when a stock's price exceeds its equilibrium level, sellers increase supply by offering more shares, buyers reduce demand by placing fewer bids, and the excess supply drives the price back toward equilibrium.

When the actual market price is below the equilibrium price, the quantity demanded at that price exceeds the quantity supplied — a shortage exists. Buyers who cannot find sellers at the low price are motivated to bid the price higher to attract sellers. As prices rise, quantity demanded decreases and quantity supplied increases, eliminating the shortage until the price returns to equilibrium.

Shifts in Demand — What Moves the Entire Demand Curve

A change in price produces a movement along the demand curve — the quantity demanded changes but the demand curve itself does not shift. A shift in the demand curve occurs when something other than price changes the quantity demanded at every price level simultaneously — the entire curve moves left or right. Understanding the distinction between a movement along the demand curve and a shift of the entire demand curve is directly tested on the Series 65 examination.

The five primary factors that shift the demand curve are income, the prices of related goods, consumer preferences and expectations, the number of buyers, and future price expectations.

Changes in income shift demand for most goods in the direction of income change — rising incomes increase demand for normal goods and decrease demand for inferior goods. In financial markets, rising household wealth and income increase demand for investment assets across the board, shifting demand curves for equities, bonds, and real estate rightward. The wealth effect — in which rising asset prices increase consumer spending — is a well-documented macroeconomic phenomenon that reflects how changes in financial wealth shift the demand for goods and services throughout the economy.

Changes in the prices of related goods shift demand through two mechanisms. Substitute goods — those that can replace each other in consumption — have demand curves that move in opposite directions when one substitute's price changes. When bond yields rise, bonds become more attractive relative to dividend-paying stocks — some investors substitute bonds for stocks, shifting the demand curve for equities leftward. Complement goods — those consumed together — have demand curves that move in the same direction when one complement's price changes. When brokerage commission rates fall — as they did dramatically when major brokers moved to zero commissions in 2019 — the demand for trading securities increased because the cost of the complementary service of trade execution fell.

Consumer preferences and expectations shift demand when the underlying desire for a good or asset changes independently of its price. Changes in investor risk sentiment — driven by economic news, geopolitical developments, or changes in monetary policy expectations — shift demand curves for equities, bonds, and other financial assets simultaneously without any change in the current price of those assets.

Future price expectations shift current demand — an investor who expects stock prices to rise significantly in the near future will increase their current demand for stocks even at current prices, shifting the demand curve rightward. Similarly, if investors expect interest rates to rise — which would reduce bond prices — current demand for bonds shifts leftward as investors sell bonds today to avoid the anticipated future price decline.

The number of buyers in the market shifts demand — as the pool of potential investors in a market grows, demand for the assets in that market shifts rightward. The globalisation of financial markets — which progressively opened US equity markets to international institutional investors — expanded the pool of potential buyers for US equities, contributing to the long-term rightward shift in demand for US stocks that sustained the secular bull market of the 1980s through the 2000s.

Shifts in Supply — What Moves the Entire Supply Curve

A shift in the supply curve occurs when something other than price changes the quantity supplied at every price level simultaneously. The primary factors shifting supply are input costs, technology, the number of sellers, government policy, and future price expectations.

Changes in input costs shift supply in the opposite direction — when production costs rise, supply decreases — the supply curve shifts leftward — because each unit costs more to produce and some previously profitable production becomes uneconomic. In financial markets, the supply of new equity and debt securities is affected by the cost of capital — when interest rates rise and the cost of issuing new debt increases, the supply of new corporate bond issuance decreases.

Changes in technology shift supply rightward — technological improvements that reduce production costs allow producers to supply more at every price level, shifting the supply curve outward. In financial services, technological improvements in trading platforms, risk management systems, and information processing have progressively reduced the cost of providing financial services, shifting the supply curve for financial products and services rightward.

Government policy shifts supply through regulation, taxation, and subsidies. A new tax on capital gains increases the cost of realising investment gains, potentially shifting the supply of securities available for sale leftward as investors reduce their willingness to realise taxable gains at existing prices. Regulatory requirements that restrict the ability of financial intermediaries to hold certain assets reduce the supply of credit available to borrowers, shifting the credit supply curve leftward.

Supply and Demand in Financial Markets — The Credit Market

The supply and demand framework applies directly to the credit market — the market in which lenders supply funds and borrowers demand them. In the credit market, the price is the interest rate — borrowers pay the interest rate for access to funds and lenders receive it for supplying funds. The equilibrium interest rate is the rate at which the quantity of funds that borrowers want to borrow equals the quantity that lenders are willing to supply.

The Federal Reserve's monetary policy operates directly through its influence on the supply of credit in financial markets. When the Federal Reserve purchases Treasury securities through open market operations — quantitative easing — it injects reserves into the banking system, increasing the supply of loanable funds and shifting the credit supply curve rightward, driving interest rates lower. When the Federal Reserve sells securities through open market operations — quantitative tightening — it withdraws reserves, reducing the supply of loanable funds and shifting the credit supply curve leftward, driving interest rates higher.

Changes in the demand for credit shift the credit demand curve. When businesses are optimistic about investment opportunities — expecting high returns on new projects — their demand for borrowed funds increases, shifting the credit demand curve rightward and pushing interest rates higher. When businesses are pessimistic — during recessions when investment opportunities are scarce — credit demand falls, shifting the curve leftward and pulling interest rates lower.

Supply and Demand in the Stock Market

In the equity market, the supply and demand framework explains how stock prices are determined through the continuous auction process of the national market system. The demand for a company's shares reflects investors' assessments of the present value of the company's future cash flows — the higher investors believe those future cash flows will be, the more they are willing to pay for the shares, and the rightward their demand curve is positioned. The supply of shares available for purchase reflects the willingness of existing shareholders to sell at various prices — at higher prices, more existing shareholders are willing to realise their gains or exit their positions.

Earnings surprises shift the demand curve for equities immediately and dramatically — when a company reports earnings significantly better than expected, investors revise their assessment of the company's future cash flows upward, shifting the demand curve for the stock rightward and producing an immediate price increase to the new higher equilibrium. Similarly, a negative earnings surprise shifts the demand curve leftward, producing an immediate price decline to the new lower equilibrium.

Macroeconomic developments shift the demand curves for broad equity indices — a Federal Reserve interest rate cut shifts demand rightward by reducing the discount rate applied to future corporate earnings, increasing present values and making equities more attractive relative to fixed income alternatives. An unexpected inflation increase shifts demand leftward by raising the discount rate and eroding the real value of future corporate earnings.

Price Elasticity — The Responsiveness of Quantity to Price

Price elasticity of demand measures the responsiveness of quantity demanded to a change in price — quantifying how sensitive buyers are to price changes. Elastic demand — elasticity greater than one — means that a one percent price increase produces a greater than one percent decline in quantity demanded. Inelastic demand — elasticity less than one — means that a one percent price increase produces a less than one percent decline in quantity demanded.

Financial assets that have close substitutes — competing investment options with similar risk-return profiles — tend to have more elastic demand, because a price change that makes one asset less attractive relative to its substitutes produces a larger shift in demand toward those substitutes. In the currency market — where different currencies are close substitutes for international investors seeking real returns — demand is often highly elastic to changes in relative interest rates and expected currency appreciation.

Supply and Demand and the Fiduciary Framework

Under the fiduciary duty of the Investment Advisers Act of 1940 and the care obligation of Regulation Best Interest at 17 CFR 240.15l-1, investment advisers and broker-dealers who provide market analysis and investment recommendations must understand how supply and demand dynamics affect the prices and returns of recommended securities. An adviser who recommends a security without understanding the supply and demand factors that will affect its price — including competitive dynamics, regulatory environment, monetary policy effects, and investor sentiment shifts — may fail the care obligation's requirement to exercise reasonable diligence in understanding the potential risks of a recommended investment.

Examination Relevance and Key Takeaways

Supply and demand is tested on the Series 65 examination in the context of market price determination, the factors that shift supply and demand curves, equilibrium price and quantity, and the application of supply and demand principles to financial markets including equity markets, credit markets, and currency markets.

The key points to retain are these.

The law of demand states that there is an inverse relationship between price and quantity demanded — when price rises, quantity demanded falls, all else equal. The demand curve slopes downward from left to right. The law of supply states that there is a direct relationship between price and quantity supplied — when price rises, quantity supplied increases, all else equal. The supply curve slopes upward from left to right. Market equilibrium is the price at which quantity demanded equals quantity supplied — the self-correcting market mechanism drives prices toward equilibrium through the elimination of surpluses — where quantity supplied exceeds quantity demanded at above-equilibrium prices — and shortages — where quantity demanded exceeds quantity supplied at below-equilibrium prices.

A movement along the demand or supply curve is caused only by a change in the price of the good or asset itself — all other factors held constant. A shift of the entire demand curve is caused by changes in income, prices of related goods including substitutes and complements, consumer preferences and expectations, number of buyers, or future price expectations. A shift of the entire supply curve is caused by changes in input costs, technology, number of sellers, government policy, or future price expectations. Rightward demand shifts and leftward supply shifts both increase equilibrium price. Leftward demand shifts and rightward supply shifts both decrease equilibrium price.

In financial markets the price is the interest rate in the credit market — Federal Reserve open market operations shift the credit supply curve by injecting or withdrawing reserves, directly affecting the equilibrium interest rate and all asset prices. In the equity market, supply and demand determine stock prices through continuous auction — earnings surprises, monetary policy changes, and shifts in investor risk sentiment all shift the demand curve for equities, producing immediate price adjustments to new equilibrium levels. Price elasticity of demand measures the responsiveness of quantity demanded to price changes — elastic demand produces larger quantity responses to price changes than inelastic demand, with close substitute availability being the primary determinant of elasticity.