Stock market efficiency and economic efficiency: is there a connection?

Article 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. (Reprinted by permission of the publisher.)

Capitalism, Efficient market theory

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Stock markets, growth, and tax policy

Article Abstract:

An extensive literature documents the role of financial markets in economic development. To help explain this relationship, this paper constructs an endogenous growth model in which a stock market emerges to allocate risk and explores how the stock market alters investment incentives in ways that change steady state growth rates. The paper demonstrates that stock markets accelerate growth by (1) facilitating the ability to trade ownership of firms without disrupting the productive processes occurring within firms and (2) allowing agents to diversify portfolios. Tax policy affects growth directly by altering investment incentives and indirectly by changing the incentives underlying financial contracts. (Reprinted by permission of the publisher.)

Security and commodity exchanges, Interpretation and construction, Tax law, Economic aspects, Economic development, Financial markets

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Implications of the discreteness of observed stock prices

Article Abstract:

Organized stock exchanges only allow stock prices to be divisible by one-eighth, which makes 'true' prices different (usually) from the observed price. The biases that result from the discreteness of observed stock prices are examined, with it shown that the natural estimators of the variance and of all the higher order moments of the rate of returns are biased. Also derived are an approximate set of correction factors, as well as the outline of a procedure that can be used to make the correction. It is shown that the natural estimators of the 'beta' and of the variance of the market portfolio are 'nearly' unbiased.

Models, Stocks, Investments, Mathematical models, Equilibrium (Economics)

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