Economics is all about theory. And in theory, money flows about the world in predictable, fair and efficient ways.
In theory.
In a perfect economic world, companies would compete with each other, eternally striving towards monopoly–one company completely controlling the market for a product–but instead locked in perfect competition, driving prices towards a minimum. This minimum would be high enough to cover the cost of the materials and production, but low enough that people would not be willing to pay a cent more.
This is the point of zero economic profits. It’s different from what we think of as business profits. An economic profit means that you managed to take some money off the table that you shouldn’t have been able to take…that you should be able to sell it for a buck based on what it costs to produce and a reasonable markup that mirrors what the industry expects the markup to be, but you sold it for a buck and a quarter. That’s a quarter you shouldn’t have been able to make. But you did. Somehow.
For some products, a very small price increase means that the demand drops to nothing; nobody is willing to pay a penny more. That’s called a high price elasticity of demand–you have that a lot in commodity items, or items where there’s no real quality difference between one producer’s brand and another, like grain or road tar or other raw materials. You’re not going to pay an extra nickel per ton of somebody else’s gravel. But for a nickel less, you’ll buy a lot more. And then there’s a low price elasticity of demand, where you can move the price up or down quite a bit before it impacts how many people want to buy it. Gasoline is a great example of that.
In theory, markets are efficient. That means that the price of a stock should include everybody’s assumptions about its future performance, and shares of AAPL shouldn’t jump when Steve Jobs takes the stage and announces the latest iSomething. When you pay $250 a share, that includes the belief that Apple is going to come out with all kinds of innovative products at various points in time, which is what makes it worth that share price.
Opinion time: reality–Enron, the real estate bubble, the tech bubble, and countless other stories of free market systems gone wrong–has convinced me that markets are anything but efficient.
Apple’s stock price does change, because people aren’t rational, and efficient markets count on people acting like little economic machines–or that everything will even out in the end, because irrationality in different directions will average out to sensible behavior. If that’s true, I haven’t seen it.
You’ve read it before, and you’ll read it again before MBA-A-Day is done: people are messy.