The Basics of economics, the price mechanism and utility maximization

How stocks change in value and how they are bought and sold

Brokers, the global network of stock exchanges, margins, and short-selling

The Basics

Before we dive into the nuts and bolts of what makes the stock exchange tick we have to cover the basics of economics: Demand and supply, how the price mechanism works, and utility/profit maximization. In determining the price of a good (not just shares) we must first define demand and supply and find out how to price a certain good.

Demand is the ability and willingness of a consumer to buy a certain good or service at a certain price.

As you'll probably expect, the more expensive an item is, the demand for the item would be lower.This indicates a negative correlation between price and demand, where if price increases, demand decreases.

Supply is the ability and willingness of a producer to produce certain goods and services at a certain price. Therefore, it has a positive correlation with price, as more producers are willing to supply goods as higher prices.

Thus, when charted, the demand and supply graph will look like this:

In this graph, the Y axis represents price and the X axis represents the quantity demand. We can see that at a low price, the demand of a product outstrips the supply of a product. Similarly, at higher prices, the supply of a product outweighs the demand for a product.

However, in that graph, there exists a point economists call the equilibrium.That point is expressed as where the two lines intersect, represented on the graph as Q1 and P1. Q1 is the quantity to be sold and P1 is the price at which a good or service will be sold.

In reality though, the market is rarely in equilibrium due to certain complex factors such as price ceilings and price floors.

However, do note that prices can change if demand or supply changes. If demand graph increases (due to external/non-price factors like marketing), the price of a good can increase.

The price mechanism and utility

The price mechanism is, simply put, how prices are determined. In the previous section you have already seen how prices are determined by demand and supply. In a financial market, the demand and supply of an financial instrument can be seen via the asking price of a stock, quotes by a buyer and the volume of a stock.

In a free market, demand and supply is also affected by another set of factors: Utility and profit. Utility and profit are the driving forces behind demand and supply.

Utility is a good's perceived value to a consumer, be it by virtue of satisfaction or other means.

Profit is the earnings by a producer of goods and services.

Within the price mechanism, imagine a tug-of-war of price between producers and consumers where consumers want lower prices and producers, higher. The driving force behind this is Utility maximization and Profit maximization. It is the goal of the consumer to maximize utility and the goal of the producer to maximize profit.

How shares change in price.

Now having known how the price mechanism works, let's look at how shares change in price.

Shares, in addition to the pricing mechanism, have an additional layer of factors to incorporate into the price of a share. Since a share represents a part of the company, a share is also affected by the earnings of a company, it's net worth and other smaller factors.

If a company is not doing well and has reported a loss, the value of a share will fall. This is as the value a share represents in the company has decreased in value. How a share does in the stock market is decided by many Fundamentals. Fundamentals are statistics that paint a portrait of a company and it's current financial health. An example of a fundamental is the Price/earnings ratio (PE ratio).

A stock can be affected by other external factors too, such as the stock price of rival companies, rumors and speculators. Speculators are investors that carry higher risk than normal.

In the stock market, the prices of shares are to fluctuate and if the price of a stock fluctuates too much, the stock is said to be Volatile. Fluctuates means changes in price.

How shares are bought and sold

Shares in a stock market are bought and sold via trades.

In the past, trades have been carried out via Barter. However, as civilization progressed, we have developed a common medium of exchange, namely, money. Today, all trades on this planet are carried out via the use of money.

In a stock market, trades are carried out via a system of bids and asks. A bid is the maximum price a buyer is willing to pay and the asking price is the maximum price a seller is willing to receive. An additional indicator would be the quotation: The most recent price at which a sale took place.

However, the system of asking and bidding is on it's way out of the door as new, modern systems like high-frequency trading takes its place. Most trades executed nowadays are from automated software carrying out thousands of trades per second.

A place where trades occur is called an Stock Exchange. Some of the most famous exchanges in the world include the New York Sock Exchange (Pictured) and the London Stock exchange (lovingly called the "Footsie").

Brokers

Well, because you cannot trade physically on the stock exchange, you have to trade via a Broker. Brokers are the actual people on the trading floor buying and selling shares. Whenever you buy/sell a stock, you are actually giving an order to a broker to execute your trade.

Brokers work under a company called a Brokerage. This is important as whenever you trade, you will be charged Brokerage fees. Comparing fees to find the cheapest is essential to maximizing profit.

The exchange

Throughout this website, the term "Exchange" has been used rather frequently. But what exactly is it?

A stock exchange is where brokers buy and sell shares. Within the exchange there are two markets: The Primary market and the Secondary Market. The primary market is where you would buy stocks from a company, like in an IPO. The secondary market consists of individuals trading within themselves. In relation to you, as an investor, you would most probably use the secondary market.

Any security traded in an exchange is said to be a listed security.

Within an exchange, there are many different types of markets selling different securities and financial products. For example, we have the Stock market, the forex market, commodities, bonds, etc. Additionally, like any other market, it has opening and closing times and public holidays are observed, such as Christmas.

Think of it as a huge wet market, selling different products. For example, in a wet market you can find fish, vegetables, meat, and other produce. The exchange works in a similar way with different products.

Margins and Short-selling

Besides buying and waiting for a stock to rise, there are multiple other options to trade stocks. One other common option is Short-selling.

Short-selling is the practice of buying a stock, with the promise to the buyer to pay him back at the price at a later date. Meanwhile, a short-seller would immediately sell the stock for the current price. This effectively, is the reverse of buying a stock, where you are betting on the stock to go down. If the price of a stock falls, then the short-seller would back the original seller less than what the short-seller got from selling the stock immediately.

In the exchange, another practice used by Investors is the use of Margins.

Margins are effectively, loans from the brokerage to buy financial instruments. Unlike traditional loans however, financial instruments are used a collateral and the borrower has to maintain a minimum balance in his/her investing account. However, margin trading is extremely risky and is not recommended for those with low risk tolerances.