1.7 Efficiency in Market Prices

Nobel Laureate economist Milton Friedman was interested in the subtlety of prices in an economy. Friedman discussed the three roles of prices. First, prices convey information to consumers. For example, we might see a gallon of milk on sale priced at $3 and suddenly become motivated to buy it. Perhaps the newly priced milk is of lower quality, or the grocer has excess inventory. Either way, we can infer something informative about the change in prices. Second, prices affect incentives. For instance, a sophisticated consumer might not be in the market for a brand new car at its current price. However, the dealership could incentivize the consumer by dramatically lowering the price. Third, prices affect the distribution of income. Nearly all students would agree that the price of garbage collection is lower than the price of health care. Thus, it should come as no surprise that the providers of health care (doctors) earn higher wages than providers of garbage collection.

Likewise, prices in financial markets also convey information, affect incentives for investors, and similarly affect the distribution of income for both the investor and the firm that has issued the security. In this section, we are most concerned with the first role of prices in financial markets. When we discuss whether market prices are efficient, we are interested in determining whether prices fully reflect all of the available information about a particular security. Markets that are efficient will have prices that fully reflect the available information about a specific security. Markets that are inefficient will have securities that are mispriced, or the security prices will not reflect all available information.

Take, for example, a company that has recently announced unexpectedly strong earnings. Upon the announcement, an efficient market will bid up the stock price of the company to fully reflect the strong earnings. Another example might be a company that has recently been named as a defendant in a class-action lawsuit. Upon the announcement of this class-action lawsuit, if stock prices take months to reflect this information, this might be evidence of market inefficiency. The purpose of discussing the price response to new information is based on the idea that as firms make sound, profitable decisions, their stock price (in an efficient market) should increase in relation to the firm’s profitability. In the next section, we will discuss this in more detail.