Demand, supply and equity prices

B. Venkatesh

THE other day, my friend wanted to know how equity prices are determined. For instance, why is Infosys trading at Rs 6,800 and not, say, Rs 5,000? We can attribute prices to demand and supply. By that we mean Infosys is Rs 6,800 because there is demand/supply for the stock at that price.

If Infosys is, say, Rs 5,000 the demand for the stock may be higher. This higher demand will prevent sellers from selling at that price. Buyers will, therefore, have to necessarily increase their price for the stock. Suppose some buyers increase the price to Rs 5,700, some sellers may be willing to sell at that price. This process goes on endlessly as buyers and sellers fulfill their wants in the market.

This example suggests that trading is a price discovery process where there is continuous matching of demand and supply for a stock concerned. In some ways then, the equity market is similar to the auction for antique furniture, where the auctioneer tries to match buyers for a price.

But there is a difference. In a stock market, there are many buyers and sellers unlike in an auction, where the seller, in most cases, is a single entity.

The presence of many buyers and sellers results in continuous bidding of prices, which is one reason why it is difficult to visualise the market as an auction process.

An auction process is easily observable in fixing the gold price in London by the representatives from 5 bullion houses. The chairman first suggests an opening price. The representatives then indicate whether they want to buy or sell gold at that price. Based on the position, the chairman announces a new price. This process goes on till buy and sell positions are equal at some price.

The auction process in the stock market is different in that the bidding is conducted on a real-time basis. This makes it difficult for us to observe the process as in the gold-fixing.

In short, the price of Infosys is a function of `simple economics' -- demand and supply.