The Economics of the Stock Market

In a way stock markets are an example of perfect competition. There are hundreds of buyers and sellers, with equal access to regularly updated information. We can assume most stock market traders are rational people who seek to maximise their profits. There are few barriers to entry and exit; anybody can buy shares if they have enough money. Shares in one company are homogenous.

But despite this, stock markets tend to behave erratically with large swings in share prices. This suggests that the market is not perfectly competitive.

For example, if investors have perfect information how do we explain stock market crashes?

1. Herding behaviour. ‘Wisdom of the Crowds’

It is often assumed that if markets are rising there must be a good reason for the rise in prices. If professional investors are buying dot com shares why should we not? Therefore, it is often the case that people get caught up in the prevailing mood of the market.  When prices rise this encourages other people to buy. When prices fall the opposite occurs and investors seek to sell before prices fall anymore.

2. Information is poor.

The other assumption is that investors have accurate information. Firstly, it is difficult to be completely aware of the current profits of a company. But the key for share prices are forecasts for the future. People buy shares on expectations of future profits. However, there are many factors that can make it difficult to accurately predict profit growth. Often profit forecasts are extrapolated by looking at past profit trends. However, just because a company has had profit growth of 20% for the past 5 years, there is no guarantee it will continue to have similar profit growth.

Importance of Stock Market on the Economy

The stock market is an important source of company finance, which offers greater flexibility than borrowing from banks. Companies can list on the stock market and sell their shares. This enables them to gain finance to invest. For example, a stock market flotation was very important for Eurotunnel to gain the necessary funds to invest in the long term project of building channel tunnel.

How The Stock Market Affects the Rest of the Economy

A fall in share prices can adversely effect the wider economy. If share prices fall, investors will see a fall in wealth, this may make them more reluctant to spend. This can cause a fall in economic growth. However, the impact of this is relatively limited. Most people who buy shares don’t rely on this invested money for consumption. It would need a prolonged fall in share prices to change consumer spending. For example, after 1987 stock market crash (share prices fell 25% in a week), it did not cause a fall in economic growth.

See more: How the Stock Market effects the economy

Factors Affecting the Stock Market

Share prices can rise or fall depending on a number of factors

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