This page is designed to give a very basic overview of some of the fundamental economics concepts that may be relevant for investment banking interviews and internships. It by no means provides a substantive account and far more reading, research and study is required to gain a solid grounding in the subject. Microeconomics may be of greater use when engaging in case studies, whereas macroeconomics may be of greater use when discussing current affairs.
Microeconomics: Supply & Demand
Microeconomics studies the interaction between buyers (consumers) and sellers (firms) and the factors that influence their decisions. It can provide an insight into the ways in which setting different prices for products will affect the quantity of products demanded (purchased) by consumers, which in turn can help sellers to determine the optimal price they should charge for products and the quantity of products that they should produce at that price to achieve maximum profitability.
- Supply: the quantity of a product or service available for consumers to purchase at a specific price.
- Demand: the quantity of a product or service that consumers are able and willing to purchase at a specific price.
If demand for a product increases to a greater extent than the supply of that product, firms may be able to charge a higher price for it. This is especially the case if there is an excess of consumers competing to purchase the product at a particular price. In such instances, whilst a price rise would inevitably deter some consumers from purchasing the product, the excess demand that had existed at the lower price indicates strong demand should still exist at a slightly higher price. However, if prices are increased too dramatically, demand may fall to a level that generates less profit overall than would have been generated at the original price.
Accordingly, for a company to generate optimal profit levels, a balancing act must be struck between generating as much profit as possible per individual sale and generating as many sales as possible. In contrast, if supply increases to a greater extent than demand, firms may have to reduce prices to increase demand (and thus ensure a greater number of products are sold overall). There are numerous elements that can affect supply and demand:
1. Price / Output
Analysis of supply and demand trends can inform business decisions relating to the price at which products should be sold to consumers and the quantity of goods that should be produced by firms (firm output) at each potential selling price. This is because such analysis can provide an insight into the ways in which consumer demand (the quantity of sales made) will fluctuate at different price levels.
Naturally, as prices increase, demand will usually fall, as fewer consumers will be able or willing to purchase the goods in question. For instance, a supermarket may sell 1000 apples in a day if they charge 30p per apple, but if the price charged were to rise to £1, the number of sales would likely decrease significantly. However, the way in which price affects demand varies depending on the type of product being sold.
- Price Elasticity Of Demand: measures the extent to which price changes affect demand. Price-elastic products are products for which demand changes significantly in response to price changes. Examples include necessities (every-day household items) or generic items that can easily be purchased from other suppliers. Price-inelastic products are products for which demand changes less dramatically in response to price changes. Examples include luxury goods such as designer items, which are less easily substituted by other products.
2. Competing Goods
- Demand may be affected by the price of identical or similar goods. For instance, if Supermarket A sells their own brand of baked beans for 50p and subsequently Supermarket B reduces the price of its own brand of baked beans to 30p, demand will likely fall for Supermarket A’s baked beans and increase for Supermarket B’s.
3. Substitute / Complementary Goods
- Substitute Goods: products that a consumer could purchase to satisfy the same purpose, need or want as a different product sold by another company. For instance, a train ticket may be a substitute for a plane ticket (if the route is similar) and if the price of rail travel drops, consumers may consequently decide to take a train rather than fly where possible.
- Complementary Goods: products that can or must be purchased alongside another product. For instance, petrol is a complementary product to cars. If the price of petrol dramatically increases, consumers may (in the long term) be less inclined to purchase cars.
Demand may also be affected by the price and availability of substitute goods or complementary goods. For instance, a fall in the price of a substitute product may increase the demand for that product and consequently reduce the demand for goods to which the substitute product serves a similar purpose. In contrast, a fall in the price of a complementary good may increase demand for products to which it is a complement, as the cost of the overall package will reduce.
4. Input Costs / Profit Margins
The quantity of goods supplied may also depend on the input costs involved in producing the goods. If costs are low and the potential profits are high for a product, supply will likely increase as it is more beneficial for firms to produce and sell this product (existing firms may increase output and other firms may enter the market). If supply increases, firms may end up having to consequently compete on price in order to generate additional sales, resulting in the price decreasing for consumers.
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By Jake Schogger - City Career Series