Financial Concept Undergraduates Must Know(Part 3)

Why supply and demand rule

For the most part, prices are set by the interaction between supply and demand. If demand for something suddenly shoots up and the available supply of that something doesn't change, then prices will increase. If demand drops or supply increases, prices typically fall.

Here's an example. Say football star Ronaldo is photographed wearing a cap with the brand name of Merah Jambu. Suddenly, all his fans and half the people reading Football magazine decide they, too, need the Merah Jambu hat. The farm supply companies that stock these hats figure out a good thing when they see it, and double, then triple, the price. The hat actually worn by Ronaldo sells for a mint on eBay, earning a notice in mainstream newspapers and furthering the craze.

The Merah Jambu company wants a piece of this action and starts cranking out hats by the ton. Suddenly you can find one in every Carrefour and Wal-Mart. The retailers can no longer command a premium for having a rare item, thanks to the increase in supply. In fact, the hats start seeming a heck of a lot less cool, lowering demand; Carrefour and Wal-Mart slash the price still further to get rid of their unwanted supply.

Supply and demand have a lot to do with our incomes as well. If we have rare skills that are in high demand by employers, we can negotiate higher pay. If, on the other hand, a lot of people can do what we do or the employer need for what we do is limited, our incomes are likely to be stunted.

The time value of money



This boils down to a relatively simple proposition: that the dollar I get today is worth more than a dollar I'm promised sometime in the future.

There are several reasons for this. One is the "bird in the hand" reality: the dollar I get today is real, but the dollar I'm promised in the future likely will be worth less (because of inflation), or I might not get it at all (you might renege on your promise to give it to me, or die, or cease operations if you're an employer or business). Also, the dollar I get today can be invested to create more dollars in the future.

Turn this around, and you'll see why lenders charge interest for loaning money -- and why the interest rate depends on your creditworthiness. Lenders want to be compensated for the erosion in their dollars due to inflation, and for the risk of lending money to you.

The higher the perceived rate of future inflation and the more lenders doubt your promise to pay the money back, the more interest they'll charge to compensate for the risk.