Price Efficiency Definition Examples How It Works

Price Efficiency Definition

Explanation

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. 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.

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Examples of Price Efficiency

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

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 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.