Question

In the market for Amazon.com stock, explain how each of the following events, ceteris paribus, would affect the demand curve for the stock and the stock's price. a. The interest rate on U.S. government bonds rises. b. People expect the interest rate on U.S. government bonds to rise, but it hasn't yet risen. c. Google announces that it will soon start competing with Amazon in the market for books, DVDs, and everything else that Amazon sells.

Short answer

Each of the mentioned events - rising interest rates on U.S. government bonds, anticipation of such an increase, and increased competition from Google - leads to a leftward shift in the demand curve for Amazon.com's stock. The corresponding impact on the stock's price is negative in all cases, assuming all other factors remain constant.

Step-by-step solution

Analyze Impact of Increased Interest Rate

An increase in the interest rate on U.S. government bonds makes these bonds more attractive as an investment. As such, demand for alternative investments, in this case Amazon's stock, decreases. With all other factors remaining constant (ceteris paribus), this leads to a leftward shift in the demand curve for Amazon's stock, consequently lowering its price.

Consider Expectation of a Future Interest Rate Increase

The expectation of a future interest rate increase causes investors to rethink their portfolio strategies. At this stage, even if the actual interest rate hasn't increased yet, investors may start selling their stocks or withholding from buying more in anticipation. This reduces the demand for the stock, shifting the demand curve to the left and decreasing the stock’s price.

Evaluate the Impact of Increased Competition

The announcement from Google about entering Amazon's market space increases perceived business risks for Amazon. The new competition is predicted to hurt Amazon’s profits in the future, and thus increases downside risks for stockholders. This leads to a decrease in demand for Amazon's stock as investors evaluate these developments, once again shifting the demand curve to the left and impacting the stock’s price negatively.

Key concepts

Impact of Interest Rates on Stock Prices

When analyzing the relationship between interest rates and stock prices, it's essential to comprehend how they inversely affect one another. An interest rate hike on low-risk investments such as U.S. government bonds can diminish the allure of riskier assets like stocks. Higher interest rates mean that bonds yield more, leading some investors to reallocate funds from stocks to bonds, seeking the new higher returns with perceived lower risk.

For example, if the interest rate on government bonds rises, investors weighing the pros and cons of different investment options might find the guaranteed return on bonds now more compelling compared to the potential, but uncertain, gains from the stock market. This perception of increased attractiveness can cause a decline in stock demand, shifting the stock demand curve to the left. This shift reflects a downturn in the quantity of stock demanded at any given price, resulting in a potential drop in stock prices.

Furthermore, the cost of borrowing for companies increases with higher interest rates, which can reduce corporate profits and, in turn, diminish investor interest. As companies may pay more to finance operations or expansion, their future profitability might look less certain, negatively affecting the stock demand.

Investor Expectations and Stock Demand

Investor expectations play a pivotal role in stock demand. The stock market is as much about perception as it is about reality. If investors anticipate an interest rate increase on government bonds in the near future, they might preemptively adjust their portfolios, regardless of whether the rate hike has occurred yet.

This proactive behavior is often referred to as the 'expectations theory,' which suggests that investors make decisions not just based on current events but also on their predictions of future market trends. When expectations lean towards a bearish market, investors might sell off stocks or defer making new stock purchases, anticipating lower returns. This mindset leads to a leftward shift on the stock demand curve, indicating a drop in the number of shares investors are willing to buy at a given price, which, consequently, can depress the stock prices.

Psychological Impact

It’s not just direct financial analysis that influences investor behavior, but also their psychological response to anticipated events. This can create a herd mentality effect, where the fear of potential loss based on predictions prompts investors to act in a conservative manner, thereby influencing the demand for stock negatively.

Competition Effects on Stock Demand

Introducing new competitors into a market can profoundly impact the demand for a company's stock. When a powerful player like Google announces plans to compete directly with a firm like Amazon, investor confidence in Amazon might wane due to the expectation of fiercer competition and potentially reduced profits.

Assessment of Market Share and Profitability

Investors often gauge how well a company can maintain or increase its market share when faced with new competitors. If the entrant has significant resources, as Google does, the threat to Amazon becomes more pronounced, leading to concerns about diminished future profitability. This affects investor sentiment, who may project lower earnings and divest from Amazon's stock, causing a decrease in the stock's demand. As demand decreases, the demand curve moves left, and Amazon's stock price may drop accordingly.

Understanding these dynamics helps grasp why strategic movements in the market, such as mergers, acquisitions, or expansion announcements, can have substantial ripple effects on stock demand. The market reacts not just to current competition but also to the anticipation of future market conditions.