Basic Economic Theory Model to Explain the Volume and Price Relationship

[zkreso 10]

In this post I plan to present a simplified view of the Volume and Price relationship based on elementary economic theory.

 

First, an introduction to supply & demand schedules for those without any prior understanding of economics. For those of you who are familiar with the economic definitions of supply & demand, you can skip this part.

 

 

Introduction to Supply & Demand:

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In economics, we think of demand and supply as a schedules, or arrays of price and quantity combinations if you wish. That is, for every price, a certain quantity will be demanded, and likewise, for every price, a certain quantity will be supplied.

 

We assume that the higher the price, the less will be demanded.

We assume that the higher the price, the more will be supplied.

 

With these two assumptions, we can draw the supply and demand schedules in a diagram. If the price is on the vertical axis, and the quantity is on the horizontal axis, then the demand curve will be falling, and the supply curve will be rising, as shown in the first figure.

 

 

In the intersection of these two curves, or when the quantity demanded equals the quantity supplied, we will have reached an equilibrium. All other prices would be unstable.

 

Sidenote: Why is this? Well, if price were any higher, then the quantity supplied would be higher than the quantity demanded. There would be a surplus quantity to which there would be no buyers. Thus, price must fall to attract additional buyers to snap up this surplus. Likewise, if the price were below the equilibrium, the quantity demanded would exceed the quantity supplied. There would be a shortage, and price must rise to attract additional sellers to fill this shortage.

 

What then do we mean when we say "an increase in demand"? What we mean is that for each price, the demanded quantity is larger than previously, or, for each price, the buyers now wish to purchase more of this good than they did before - it has become more dear to them. This can be illustrated by the demand curve shifting to the left, as shown in the second figure above.

 

Likewise, "an increase in supply" means that for each price, the supplied quantity is larger than previously, or, for each price, the sellers wish to dispose with more of this good than they did before - it has become less dear to them. This can be illustrated by the supply curve shifting to the left, as shown on the third figure above.

 

 

Basic Supply & Demand theory applied to the stock market

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How is this then relevant to the stock market? Well, we're lucky enough that economic theory is general enough that we can apply its principles to any good. An economic good is simply something that people value, of which the total quantity in the world is limited. This certainly applies to stocks.

 

Using a simple supply/demand diagram, like the one above, we can illustrate all the combinations of changes in price and quantity (volume) of a good (stocks) and whether they are the cause of supply and/or demand shifts.

 

For example, the second figure above shows an increase in demand. As we can see, the new equilibrium point is at a place where the price, as well as quantity, is higher than at the previous point. Below is a picture that shows all the different combinations and their impacts on price and quantity.

 

Feel free to study the figure, but skip it if you wish, as it is not extremely important for you to be familiar with it to understand the conclusion.

 

Sidenote: As a guide to examining it, note that:

 

The first row shows the possible shifts in supply & demand that would cause the price to increase.

The second row shows the shifts that would leave price unchanged.

The third row shows the shifts that would cause price to fall.

 

The first column shows the shifts that would cause volume to increase.

The second column shows the shifts that would leave volume unchanged.

The third column shows the shifts that would cause volume to fall.

 

 

 

Conclusion

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For the conclusion, I will, with the help of the diagram above, explain each of the scenarios in it (from left to right) from a stock market perspective, and with that, what the theoretical explanations for changes in price and volume are.

 

Price rises, as a result of three things:

1. Increased Demand
   as evidenced by Rising Volume. Note that ONLY demand has increased, while supply is the same. Buyers are more eager to buy, taking the offers, while sellers opinions are unchanged. This results in lots of the sellers shares to be bought and shows up as increased volume. In stock terminology we would call this scenario "offers being taken" or "buying pressure".
    
   
2. Increased Demand and Decreased Supply
   as evidenced by Unchanged Volume. Demand increases while supply decreases, suggesting that both sellers and buyers value the stock more dearly. Buyers lift bids, but sellers lift offers, causing little to no change in volume. Hard to interpret, so let's just call it the result of some "positive event" that is instantly acknowledged by both buyers and sellers.
    
   
3. Decreased Supply
   as evidenced by Falling Volume. Supply decreases while demand stays the same, suggesting an unwillingness to sell. Price rises as there is less supply, but buyers opinions are unchanged, so there are fewer shares transacted (as there are not as many buyers at the higher price). We would call this scenario "offers being raised", or "selling drying up"
   

 

Price remains unchanged, as a result of three things:

1. Increased Demand and Increased Supply
   as evidenced by Rising Volume. Buyers are more eager to buy, lifting bids, while buyers are more eager to sell, lowering offers, so price remains unchanged, but a great number of transactions happen. We would call this scenario in the stock market for "change of ownership"
    
   
2. No changes happening
   as evidenced by Unchanged Volume. There is nothing to impact the supply and demand schedules. Bids and offers are left in place. We would call this for something along the lines of "no new information" entering the market.
    
   
3. Decreased Demand and Decreased Supply
   as evidenced by Falling Volume. Buyers are less eager to buy, while sellers are less eager to sell, so liquidity falls. It's hard to interpret this one, but it could be the result of "indecision" in both camps.
   

 

Finally, price falls, as a result of three things:

1. Increased Supply
   as evidenced by Rising Volume. Sellers are more eager to sell, so they are hitting the bids, while buyers opinions are unchanged, causing a lot of the buyers orders to be taken, and subsequently an increase in volume. We would call this scenario "selling pressure".
    
   
2. Increased Supply and Decreased Demand
   as evidenced by Unchanged Volume. The inverse of the situation where price rises on changed volume. Here it falls because both buyers and sellers hold the stock less dear. Sellers try to sell, but if both buyers and sellers instantly acknowledge the "negative event", the bids will already be lowered, so we won't see an increase in volume as in the previous scenario.
    
   
3. Decreased Demand
   as evidenced by Falling Volume. The last possible scenario. Buyers expectations fall, so they lower their bids, but sellers opinions are unchanged, and as a result, fewer shares change hands (as there are fewer available at the lower prices. We would call this scenario "buying drying up"
   

 

For a quick reference, I have summarized these scenarios in two matrices, one with the participants actions, and the other with the scenario names:

 

 

 

Applications

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What in the world can this be used for then? Well, as a simplified theoretical model it is of course not extremely realistic. Even if it were, we know that economic science can not offer quantifiable predictions, so it would still be pretty useless.

 

My thought is that it should be used as a framework for interpreting price and volume changes and their interrelations. It can also be compared to other theoretical approaches to the stock market, either strengthening or weakening their conclusions, or to interpret the use and validity of certain indicators that use volume and price.

[BlowFish 10]

Interesting first post. I look forward to seeing where you go with this. There will be some sceptics that thing you are trying to sell something based on this material. I hope they do you the courtesy of not jumping to conclusions!

 

Welcome to TL and thank you for contributing so much on post 1.

[zkreso 10]

Thanks for the welcome.

 

I don't really know how to take this further. As I said, it's pretty theoretical, so for now its only use is strengthening/weakening empirical observations and anecdotal evidence from a theoretical point of view.

 

As for me selling something, I have nothing to sell. I have not made any trading recommendations, and if I do, I would not advise anyone to follow them, unless they want the same negative returns I have.

[deanz 10]

zkreso I found your post to be very interesting, thank you for taking the time to put it together.

 

Dean.

[Copycat 10]

Great post.

 

Although I disagree with your conclusions. The change in the demand- or/and supply curve means a change in equilibruim. In a new equilibrium, there will be a new general price level or new general level of volume, or both (to keep things vague :p) IMO.

 

I think prices do not jump exactly from equilibrium to equilibrium, but gradually moving to new equilibria, or towards equilibrium. A price discovering proces.

 

To illustrate with a snapshot in time: Suppose price is at P1 for some reason. Suppliers are offering Q1 at this level. Buyers want Q2 at this level. This agreement is visible for al to see. Price P1 with Q1 volume (volume is matched quantity/ quantity exchanged. The pressure is upwards, since more quantities are wanted then offered, but you do not know this with this single transaction.

 

But if you move this trough continous time, prices will move up and down around equilibrium. And this is where most of the trades are taking place.

 

So the next moment you see a decrease in P with with shrinking volume, and afterwards an increase in price with bigger volume. You don't need to be a genius to figure out the momentary pressure is upwards. A further increase of price and volume confirms all this. Until prices are above equilibrium, where see a shrinking of volume/ drying up with increasing prices, since more quatities are being offered then wanted. Selling pressure could be bigger then buying pressure and prices are moving down again.

 

This with changes in demand/ supply as you described, more combinations of volume and price are possible.

 

But yeah, I still haven't touched any financial contracts yet and this is just way to theoratical. Just the thoughts of someone with way to much time on his hands, so don't take this to heart.

[jwat 10]

I think you've got an interesting model/framework here, can you adapt it to do some simple forecasting? Try defining states, as you've done, develop some timeframes, and see if that maps to any future tendencies in price. It seems like something that would be fairly easy to backtest.