Price EfficiencyExplained & Defined

Lisa Borga

Price efficiency refers to the concept that the price at which assets sell should reflect the possession of all of the relevant supply and demand information by market participants.

Under this investment theory, all market participants should be in possession of relevant information that could impact pricing, so it should not be possible for an investor to consistently earn excessive returns.

Though the theory of price efficiency plays a major role in modern markets, it has received criticism due to the assumption that all individuals will not only be in possession of the same information, but also that they will arrive at the same conclusions.

As a result, there are several variations on the concept of price efficiency with different assumptions regarding what amount of information is available for market participants to make educated decisions.

Price Efficiency Explained

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Price efficiency is an economic theory that states that the prices at which an asset sells should reflect the availability of all information relevant to it.

Under this theory, it should be virtually impossible for a market participant to achieve consistently excess returns because all participants have access to the same supply and demand information.

Price efficiency is a critical concept in the Efficient Market Hypothesis, which is a cornerstone of modern financial theory despite many critics questioning its validity.

According to the Efficient Market Hypothesis, the prices of all assets should reflect their fair values as participants make rational decisions based on all information making it impossible to outperform the overall market through active investment strategies.

Due to controversies regarding the applicability of this theory to real markets, there are three primary modifications of this theory.

Though each of these holds a belief in price and market efficiency, they differ in how much the adherents hold that it can be applied to real markets.

  • Strong Efficiency: In its purest form, adherents of the Efficient Market Hypothesis hold that all public and private information is reflected in the price of assets.
  • Semi-Strong Efficiency: In this form of the hypothesis, all public information is reflected in prices, which means that fundamental and technical analysis cannot be used to achieve greater gains. However, private information is not included.
  • Weak Efficiency: In this form of the hypothesis, all historical information regarding an asset’s price is reflected in its current valuation. As a result, technical analysis cannot be used to achieve greater returns.

Factors Affecting Price Efficiency

Though price efficiency is an important theory in modern financial markets in a realistic marketplace, it has its limitations.

Markets vary in how efficient they are. In many markets, asymmetries of information, high transaction costs, and other inefficiencies may regularly occur.

All of these factors may lead to price inefficiency and deadweight loss.

In addition, buyers and sellers can often be expected to interpret the value of an asset differently, even if they are all in possession of the same information.

For example, a seller may need cash quickly and be willing to sell an asset for less than what the market would indicate is its true value.

There are also more complex factors that may lead to different results, such as investors who value the stock of companies that hold larger cash reserves higher due to the belief that these companies may be more likely to pay dividends.

Different perceptions of information can result in skewed pricing of assets which means that price efficiency should generally be viewed as a theoretical concept that often may not reflect realistic markets.

Detractors of the Efficient Market Hypothesis and price efficiency also point to asset bubbles, and stock market crashes as evidence that asset prices can significantly deviate from their fair value based on human psychology and emotions rather than an actual change in the assets.

Advantages & Disadvantages of Price Efficiency

Advantages of Price Efficiency

  • Though it may not be able to be accurately applied in all cases, the theory of price efficiency can be used as a valuable tool in analyzing market behavior.
  • In a perfectly efficient market, all investors would have equal access to information and would, as a result, be in an equal position to earn profits.
  • As a facet of modern markets, price efficiency supports the fast and accurate transfer of information to all participants in a market. This allows for stable and transparent decision-making by all parties.

Disadvantages of Price Efficiency

  • The theory of price efficiency assumes that all market participants will interpret information regarding an asset in the same way. However, in realistic markets, individuals will have different opinions and, as a result, different conclusions based on the exact same information.
  • Because in a realistic market, human psychology and emotions are likely to impact pricing, it is possible for assets to be under or over-priced. This would mean that it is possible to achieve excess returns in such a scenario.
  • Real markets may be more or less efficient than others. This means that prices may be more or less efficient in certain markets.

Example of Price Efficiency

As an example, consider the stock of Company X, which is currently trading at $30 per share.

Company X just released its quarterly earnings report, which indicated that the company’s recent performance has been excellent, with better than expected profits.

The company also indicated in the report that it intends to use some of these earnings to upgrade certain capital assets, which should reduce its expenses and increase production leading to higher profits.

As a result of this news, it can be expected that there will be a greater demand among investors for Company X’s stock, and sellers who have equal access to this information will only be willing to trade at an increased price.

As a result, price efficiency will mean that no investor would be able to earn an excess return based on this information.

If, on the other hand, the company did not disclose this information publicly and it was only available to a small number of investors, the market would not be price efficient.

Those trading in Company X’s stock would have no reason to know that the stock should trade at a higher price, and those that are aware are likely to take advantage of this to earn excess returns using this information.

Key Takeaways

  • Price efficiency is the concept that an asset’s price should reflect the availability of relevant information by all parties in a market. As a result, no investor should be able to consistently earn excessive returns.
  • Price efficiency plays a major role in all variants of the efficient market hypothesis, which assumes that prices in an efficient market cannot be consistently estimated.
  • The concept of price efficiency has received significant criticism from some economists due to its assumption that the same information will be available to everyone and that they will interpret it in the same way.

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  1. Penn State "Price Efficiency and Short Selling ∗" Page 1 . September 23, 2022

  2. NYU Stern "MARKET EFFICIENCY - DEFINITION AND TESTS" Page 1 . September 23, 2022