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Price Efficiency

Updated on April 4, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

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 accessible by all.

Price Efficiency

No investor can derive excess returns because of the extra information available to them. The theory of price efficiency is based on the belief that the prices of the assets are arrived at 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.

Key Takeaways

  • Price efficiency is a theory that promotes asset prices in a market and shows that all information about the assets is provided to every market participant. Furthermore, it suggests that the need is compelling as all the asset details that may affect the price is accessible in the public domain and reachable by all.
  • This theory believes that asset prices are determined depending on the information obtainable in the market. It considers that prices and markets are effective. Consequently, the prices change upon receiving the information. Past costs are not considered a base for forecasting future prices as they reflect all available asset information. 
  • If the prices of the assets do not display the complete asset information, then prices can be overvalued or undervalued, giving rise to an inefficient market. 

Price Efficiency Explained

The concept of price efficiency explains that fact that the prices of different types of financial instruments available in the market, which may be bonds, stocks, commodities, etc reflect the information of the market accurately, which is incorporated into the market price of each asset.

The efficiency of the market is judged by the fact that how fast or how accurately the asset prices reflect the information. If this process is efficient, then it is not possible to take the opportunity of price variation to trade and earn profit or consistently achieve higher returns.

Further, 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.

It is rational for the market to absorb all the available information quickly and value the assets accordingly. However, this theory of factor price efficiency has a profound impact on the traders and investors who enter the market with the hope of taking advantage of price difference to earn profit. An efficient market will not offer this opportunity.

But in reality, markets are not always so efficient, because there are various factors that influence the prices, like the behavior of the investors and their bias towards any price movement, lack of free flow of information, or any other market dynamics that influence the prices. Therefore, there are always some traders who are able to access this price difference in advance and use it to their advantage.  

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Examples

Let us understand the concept of factor price efficiency with the help of a suitable example.

Consider an example of a company’s stock, XYZ Ltd., which is currently trading at $10. The company publishes its quarterly results on its website, which anyone can view. The results showed great profits and contained an announcement and 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. It is known as price efficiency since no investor can 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 market forces. It is created when it is better to have a single organization as a service producer in the entire industry because it can provide low-priced products. The theory of price efficiency is not expected to operate in the 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 complete information available about the asset, then prices can be overvalued or under-valued. It 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 from 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 overvalued.

Advantages

Every financial concept of price efficiency formula has its own advantage and disadvantage. Let us consider the advantages first.

  • 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.
  • This reduces or controls the tendency to speculate which creates price bubbles in the economy. Such bubbles lead to excessive undervaluation or overvaluation of the asset prices, which often misguides investors who are not well informed.
  • It helps investors who do not directly invest in the market but put funds through ETF or index funds. They gain the confidence that their money will give good return.

Disadvantages

Some disadvantages of the theory of price efficiency formula are given below.

  • The theory assumes that all individuals will react similarly 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. As a result, assets can be under-valued or overvalued, and there is a chance for making excess returns. Therefore, investors do not have any chance to derive extra returns is false in such a scenario.
  • The theory states that the prices reflect the information available and change when new information is received. It 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.
  • If market is totally efficient, the fund managers or traders who actively participate in buy and sell activities, will not be able to achieve their target of outperforming the market and consistently earn good returns for their clients.
  • The factor of due diligence of detailed analysis will not take place since traders, analysts and investors will just assume that the market is reflecting all the available information efficiently. This will negatively affect the financial reporting.
  • Excessive information may actually lead to market volatility because investors may assume that market has incorporated all information and so they may not pay much attention to sudden changes, leading to price bubbles.

Thus, the above are some notable advantage and disadvantage of the concept. But they are not always true in the real world because of many other factors which influence prices but cannot be incorporated in the market immediately, leading to price difference. It is always better to understand the asset and gain thorough knowledge of it before making the investment.

Frequently Asked Questions (FAQs)

What is price efficiency also called?

Price efficiency is also called external efficiency, a feature concerning the market in which prices always fully show each accessible detail pertinent to the securities valuation.

What is the price efficiency of the capital market?

Price efficiency theory assumes that asset prices display the control of the information available by all market participants. The theory proposes that markets are efficient as every critical information affecting valuations is public.

How do prices relate to price efficiency?

The theory of price efficiency is based on asset prices decided on the information available in the market. Therefore, it believes that prices and needs are well effective. So, the prices vary when any new detail is received.



What are the three forms of pricing efficiency?

The price efficiency theory has three versions: weak, semi-strong, and strong. The invalid form shows that today’s stock prices reflect all the past price data and that no technical survey can support investors

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