Price Efficiency Definition
Price efficiency is a theory that advocates prices for the assets in a market reflects the fact that all information about the assets is available to all market participants. The theory further suggests that the market is efficient since all the information about the assets that could influence price is available in the public domain and hence accessible by all and no investor is in a position to derive excess returns on account of extra information available to him or her.
Explanation
The theory of price efficiency is based on the belief that the prices of the assets are arrived based on the information available in the market. This theory considers that both prices and markets are efficient. As a result, the prices change when any new information is received in the market. Further, the past prices don’t serve as a basis for predicting future prices since prices already reflect all information available about the assets. The theory is sometimes criticized because the same information can’t be expected to be perceived by everyone in the same manner.
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Source: Price Efficiency (wallstreetmojo.com)
Examples of Price Efficiency
- Consider an example of a stock of a company XYZ Ltd., which is currently trading at $10. The company publishes its quarterly results on its website, which can be viewed by anyone. The results showed great profits, and an announcement was also contained along with the results that the company will expand its operations. The same is expected to result in increased profits.
- In this case, this news is available in the public domain, and all investors have access to the information. The investors will trade, keeping in mind that the prices may increase. This is known as price efficiency since no investor has an opportunity to earn extra returns due to the availability of this information.
Price Efficiency in Natural Monopoly
Natural monopoly refers to a monopoly created on its own due to the presence of market forces. It is created naturally when it is better to have a single organization as a service producer in the entire industry because it can provide products at low prices. The theory of price efficiency is not expected to operate in case of a natural monopoly since the single service provider is in a position to manage or control the prices.
However, even natural monopolies are subjected to government regulations, and they would be required to enact their pricing policies keeping in line with the regulations.
Price Efficiency Variance
If price efficiency theory doesn’t hold i.e., if the prices of the assets do not reflect the entire information available about the asset, then prices of the assets can be over-valued or under-valued. This gives rise to an inefficient marketInefficient MarketAn inefficient market represents the one which fails to exhibit the actual value of the assets. Such a market doesn't provide transparent information and is unavoidable in the real world, but it benefits arbitrage traders.read more. The same can arise to many factors such as unequal access to information, market conditions, human reactions, etc. When this happens, there are chances for deriving excess profits since the prices are not at equilibrium with the information, and the assets are either undervalued or over-valued.
Advantages
- Everyone has equal access to information, and everyone is free to use the same for their analysis.
- No one remains in a position to gain excess profits due to equal access to information, and thus, all are placed in an equal position.
- The assets are priced at their fair value and reflect the information available in the market.
Disadvantages
- The theory assumes that all individuals will react in the same manner to the information available about the asset. In reality, people can differ in opinion and arrive at different conclusions based on the same information.
- Since people can perceive information differently, there are high chances of anomalies in the prices of the assets. Therefore, investors do not have any chance to derive extra returns is false in such a scenario. As a result, assets can be under-valued or over-valued, and there is a chance for making excess returns.
- The theory states that the prices reflect the information available and changes when new information is received. This doesn’t stand true when human emotions also influence prices. Take an example of the stock market crashing down because of the general sentiment in the market.
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