Stock Market Efficiency and Economic Efficiency: Is There a Connection?

Abstract

In a capitalist economy, prices serve to equilibrate supply and demand for goods and services, continually changing to reallocate resources to their most efficient uses. However, secondary stock market prices, often viewed as the most "informationally efficient" prices in the economy, have no direct role in the allocation of equity capital since managers have discretion in determining the level of investment. What is the link between stock price informational efficiency and economic efficiency? We present a model of the stock market in which: (i) managers have discretion in making investments and must be given the right incentives; and (ii) stock market traders may have important information that managers do not have about the value of prospective investment opportunities. In equilibrium, information in stock prices will guide investment decisions because managers will be compensated based on informative stock prices in the future. The stock market indirectly guides investment by transferring two kinds of information: information about investment opportunities and information about managers' past decisions. However, because this role is only indirect, the link between price efficiency and economic efficiency is tenuous. We show that stock price efficiency is not sufficient for economic efficiency by showing that the model may have another equilibrium in which prices are strong-form efficient, but investment decisions are suboptimal. We also suggest that stock market efficiency is not necessary for investment efficiency by considering a banking system that can serve as an alternative institution for the efficient allocation of investment resources.The Journal of Finance up, it is not obvious whether its access to equity capital will be altered. This is because stock prices differ from prices in the fish market and most other markets in two ways.First, in the case of the fishmonger, the consumer decides how much fish to buy. In contrast, decisions about the allocation of investment capital are generally delegated to managers with little or no ownership stake in the firm. Managers decide dividend policy, leverage, the timing of new issues of seasoned equity and other securities, and therefore they have discretion over the amount of funding available for investing in new assets. Although the equityholders supply the capital to the firm, they do not decide directly how much capital to supply: instead, the managers do. This is somewhat analogous to the fishmonger telling his customers how much fish to buy.The stock market price is a secondary market price: it values the entire firm rather than a marginal investment. The role played by the stock price is the same as in the fish market example only in the simple case where a newly organized firm issues equity for the first time to fund its investment. In this special case, there is no managerial discretion: if investors believe that the capital can be more efficiently deployed elsewhere, or if the expected returns on the project are insufficient to induce enough saving, ...

The bright side of financial derivatives: Options trading and firm innovation

“…Although several other studies also conclude that resources are allocated more efficiently if prices convey more information, which in turn leads to greater firm value (e.g., Khanna, Slezak, and Bradley, 1994;Dow and Gorton, 1997;Subrahmanyam and Titman, 1999;Durnev, Morck, and Yeung, 2004;Chen, Goldstein, and Jiang, 2007), there is little empirical evidence of this effect on innovation.…”

“…Specifically, Holmström and Tirole (1993) and Faure-Grimaud and Gromb (2004) examine the role of price informativeness in disciplining managers and providing incentives to insiders to engage in value-increasing activities. Dow and Gorton (1997) show that, in equilibrium, the information contained in stock prices can be used to guide investment decisions because managers are compensated based on future stock prices. Subrahmanyam and Titman (1999) study a setting in which investors may obtain information unavailable to firm insiders that is useful in making investment decisions.…”

Stock Market and Economic Growth in Malaysia: Causality Test

“…There were several possible arguments have been discussed as equity market may led economic growth such as (i) There was evidence that a more developed equity market may provide liquidity that lowers the cost of the foreign capital essential for development, thus, nation with greater development of equity market tends to generate more domestic savings for economic growth (Benchivenga et al, 1996;Neusser and Kugler, 1998). (ii) The role of equity market provided incentive for managers to make investment decisions that may affect firm value in the long run (Dow and Gorton, 1997). (iii) The ability of equity markets to generate information about the innovative activity of entrepreneurs (King and Levine, 1993) or the aggregate state of technology (Greenwood and Jovanovic, 1990).…”

A Revealed Preference Approach to Understanding Corporate Governance Problems: Evidence From Canada

“…Shareholders' discount rates have been studied by many researchers usually in terms of the relations among stock prices, dividends, and earnings. 1 As noted by Stein (1996) and Dow and Gorton (1997), biases in shareholders' discount rates have no necessary implications for those used by corporate executives. The latter discount rates are critical for determining investment spending, and hence are key to understanding governance issues and possible distortions of firm behavior.…”