By contrast, the markets for financial assets---that is,
assets that represent claims on the future earnings of stocks,
bonds, and other financial instruments---function well in the
above sense. But even here further issues of efficiency arise.
Do markets for financial assets function efficiently in the
sense that the prices of the assets fully reflect the available
information about their future earning streams? If not, then asset
prices do not reflect the true values of these assets and the market,
though functioning, can not be regarded as doing so efficiently.
There is good reason to believe that where fully developed
markets exist they tend to be efficient. If they were not, any
investor, acting on the basis of publicly available information,
could profitably shift her portfolio away from those assets
whose price exceeded the present value of earnings and towards
those assets that have a present value greater than their price.
The prices of those assets whose future earnings are undervalued
would be bid up and the prices of those assets whose future earnings
are overvalued would be bid down. This process would continue until
the prices of the assets equal their present values. An exception to
this conclusion would be the presence of speculative bubbles.
It is important to note that all asset-holders need not be
well informed about the future earnings of the assets for this to
happen and the market to be efficient. All that is necessary is
that a subset of asset-holders large enough to be able to affect
the market prices of the assets be well informed.
This idea of efficient markets has some very important
implications. Where markets are efficient the prices of assets
fully reflect their present values, calculated using all available
information. Since all information about the future earnings of
the assets is reflected in their current prices, one can never
consistently increase the average return on one's portfolio by
speculative purchases and quick turnover unless one has information
that other market participants do not have. One might do
better or worse in any given year, but on average one can do no
better than one could by buying a group of assets and holding
them indefinitely.
Another implication is that changes in asset prices reflect
new information which can be favorable or unfavorable---if
the information was more likely to be favorable the price
of the asset would have already been bid up to reflect that fact.
At any point in time, therefore, the price of a given asset is
just as likely to fall as rise---relative, of course, to long-term
market trends determined by inflation, productivity change and
the reinvestment of earnings.
Of course, an individual could profit from acquiring information about
a particular asset that other investors don't have. But such profits
require the investment of costly time and energy. We would expect
that those individuals in the economy who have a comparative advantage
in ferreting out this information will do so. Free entry into this
activity will ensure that profits obtained constitute no more than a
reasonable wage for effort expended, given the natural talents of each
individual involved.
It is time for a test. Be sure to think up your own answers before looking
at the ones provided.
We noted earlier that for some types of real capital, the
markets for either the capital services or the capital goods
themselves function poorly. The rental market for clothing was
given as an example of the first type of capital, and the market
for human capital was given as an example of the second. In
other markets, like the market for knowledge and ideas, neither
the market for the services of the capital nor the market for the
sources of those services function well.