What is Price Effect?

Definition: Price effect is the change experienced in the demand of certain good or service after there’s a modification of its price. It can also refer to the consequence that a certain event has in the price of a financial instrument.

What Does Price Effect Mean?

The economic principle behind a price effect lies within the law of supply and demand. Whenever the price of a given good or service is modified there’s an effect in the number of items supplied or demanded. This means that price is, for normal goods, the key driver of quantities offered or purchased. If the price is lifted, the demand decreases and supply increases and vice versa.

On the other hand, this concept also applies to financial securities that are exposed to both internal and external realities. For example, a company with interests in a country that is experiencing political turmoil will see the price of its stocks adversely affected by this scenario if the business is very exposed to that particular location.

Finally, the price effect can also be the result of a change in interest rates, which is the case for the bond market. If interest rate rises, the price of most bonds will be reduced.

Example

James recently bought a bond from One Financial Corporation. He spent $2,000 to buy a recent issue, trusting a rumor he heard about an interest rate reduction. As the price effect state if the federal interest rate is reduced the price of bonds will automatically change upwards.

Nevertheless, the result was quite the opposite. The federal interest rate was actually raised and James’ bond fell from $2,000 to $1,430, causing him a loss of $570. This demonstrates the consequences of a price change in a financial scenario. James now has to wait until the bond matures in order to recover the capital he invested or he has to take the loss if he wants to get rid of the bond.