STOCK MARKETS - e.g, THE LAND MARKET


The total stock of land is Qf. Whatever the price, this total stock cannot be changed (aside from minor changes like draining lakes etc.) The sellers are signalling a negative demand for the thing (land in this case) - the offer curve (Oc) - the higher the price, the greater the quantity we might expect present owners to be willing to sell. By the same token, all present owners who are not selling are exhibiting a positive demand for their stock given present prices. This positve demand is labelled the reservation demand (RD) in the above figure, which is the mirror image of the offer curve (Oc). What is not being offered for sale by present owners is being retained (held onto) - that is, it is (in effect) being demanded.
The excess demand curve (XD) shows how much more land present owners and non owners want to own at each price - more is demanded over and above present holdings of land as the price falls.
The horizontal sum of the reservation demand (RD) and the excess demand (XD) is the total demand (TD) for land, or stock. It is the intersection of this total demand (TD)with the fixed supply (Sf) which determines the market price for land (Pe).

The trades we observe in a stock market are those between people who no longer want to own the stock, for whatever reason, shown by the offer curve (Oc) and those who want to own more than they presently have (which might be some or none at all) - shown by the demand for additional stock (excess demand) labelled XD above.  Offer and XD intersect at the trading price (Pe) and Qt of land (or stocks and shares) change hands between buyers and sellers.

When all these trades have been made,  the present owners are now willing to go on owning land at the present price, and are not willing to sell any.

Share Prices and Stock Market price movements.
So, what is a stock or share (or piece of land) worth?  The simple answer first - it is worth whatever someone else will pay for it.  The current market price of the share, or piece of land, or any other physical asset, is as good an estimate of what it is worth as you can get.  The current price reflects the total demand (reservation and excess demand) matched with the fixed available supply.  The price will change, as in all markets, only if demand shifts or supply shifts. For land and stock markets, the shifts in total supply are usually pretty trivial compared with the total stock.  So it is shifts in demand which are critical in determining prices in these stock markets.

What will shift the demand curve for land (or stocks and shares) and hence change their prices?

The two values are related because the market price can be interpreted as the market buyers expectations of future earnings or returns. The key relationships can be illustrated through this perpetual asset: PV = R/i = Market Price of the asset: So, if a particular company discovers a new recipe for making profits, its annual returns (R) will be expected to increase, and its share price will increase until the internal rate of return falls back in line with the market rate of interest - given the risk element of the company and expectations of inflation.  Conversely, if the company falls on hard times, because its market is shrinking or because it is being badly managed, its returns will fall and its share price will fall as well, until the internal rate of return is once more in line with the market rate. 

Or, this may happen just because the financial (stock) market generally thinks this to be true - these markets tend to exhibit bubbles, market sentiment finds particular stocks attractive or promising (like IT stocks) and demand increases (against a more or less fixed supply of such stock) - so prices of the stocks rise, and people begin to anticipate capital gains - buy now and sell later, when the price is higher - this adds todemand and pushes the price higher, re-inforcing the expectations of the stock traders. Prices spiral upwards until a panic sets in about when the now unrealistic prices (not justified by their annual expected earnings) will collapse - the collapse is likely to be sudden, and to also overshoot the realistic long term price,  for the same cumulative or herd instinct reason - get out now before the price falls even lower, exacerbated by short selling - brokers and others selling shares they don't yet own, hoping to buy  them at a lower price just beforethey actually have to deliver the share certificates to the new owner.

Suppose we do not expect rents to remain constant in the future.  What might they do?  They might be expected to increase (or fall) by some average and constant amount each year (say plus or minus £A per year).  In this case, the relevant sum for the present value of this stream of future rents (annual returns) becomes:
 PV = R/i + A/i2 , where R is the basic rent or annual return (expected this year) and A is the amount by which we expect this annual return to change each year in the future, and i is the discount rate (the opportunity cost of capital - what we could earn elsewhere, investing in something else).  So, if we expect returns to fall, the present value is reduced compared with the simple sum which assumes the return stays constant.  But, if we expect returns to increase, then the present value increases, too.

Or, we might expect a continual percentage change in the annual return, say plus or minus g% per year.  In this case, the PV sum becomes:
PV = R/(i - g), so that, if the expected growth rate (g) in the returns on this asset are higher than the opportunity cost of capital (i), the present value for this asset goes to infinity: there is no price it is not worth paying for such an asset - which is an explanation of why share prices shoot upwards for companies expected to do very well in the future.

Depreciating assets - ones that wear out.
So, how do we account for the fact that physical plant and equipment wears out and becomes obsolete?  By making an allowance for the depreciation of the asset - the continual re-investment necessary to maintain it in a non-depreciating state.  Suppose that this depreciation rate is d%.  The gross return we need to get from this asset needs to cover this depreciation rate, so the net return we need to get on any depreciating asset is the gross return minus the estimated depreciation rate.  So, the gross return we expect to get should be i = r + p + u + d on these assets.

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