Market Efficiency Economics 328 Spring 2005

Why Are Markets Efficient? Economists often say markets are “efficient.” Maximize total surplus All mutually beneficial trades occur Efficiency is driven by the pricing mechanism. We need to get marginal benefit equal to marginal cost. The pricing mechanism aggregates information on the marginal benefits and costs, and forces equality across agents. In other words, markets work because of their ability to aggregate information across individuals.

Efficient Market Hypothesis The same sort of information aggregation arguments apply to financial markets. Price of a security should reflect its true value Implies that all mutually beneficial trades (and investments will take place) Efficient market hypothesis Weak: All publicly available information should be fully incorporated in security prices Strong: All information, public and private, should be fully incorporated in security prices Experiments like the one we ran today are tests of the strong efficient market hypothesis.

Experiments on Information Aggregation Random walk hypothesis Sunder and Plott (1982) A group of insiders are perfectly informed about the value of a risky security This information rapidly disseminates to uninformed outsiders Plott and Sunder (1988) Study the ability of markets to aggregate information Each trader has a different noisy signal about the true value of a risky asset Ability to aggregate information depends on the structure of the market If information is especially clear (due to common preferences), aggregation is more likely to occur If information is rich (more securities), aggregation is more likely to occur