The Efficiency of Markets – Guide Notes

Further and deeper exploration of paradoxes and challenges of intuition and logic can be found in my recently published book, Probability, Choice and Reason.

The Efficient Market Hypothesis (EMH), in its strictest form, holds that market prices or odds reflect all known information.

Prices or odds may change when new information is released, but this new information is unpredictable.

So the best estimate of the price or odds likely to prevail at any point in the future is the price now. This is dismal, if true, because it would mean that it is not possible to beat the market, except by chance. But this can’t be true, or else it creates a paradox. If the market was always efficient, traders would have no economic incentive to acquire information, since information acquisition and processing is not a costless activity and would add nothing to what can be obtained by simply looking at current market prices.

It has been mathematically proved (Grossman and Stiglitz, 1980, American Economic Review) that when information is not costless to obtain or process, asset prices can never fully reflect all the information available to traders. So in the real world, markets are not completely efficient. They cannot be. This result is a relief, at least in principle, to those seeking to beat the market.  

The equilibrium proposed by Grossman and Stiglitz is one in which some profits are available to some investors.

Essentially, rational, ‘informed’ traders will seek to acquire and process new information whenever the benefits of doing so are greater then the costs. Up to the point, economists say, where the marginal costs equal the marginal benefits of obtaining and processing information.

But to the extent that trading is a zero-sum game, or worse, as most betting markets are, winners need losers.

So who are the winners and who are the losers?

To take the example of a poker game, good players need weak players in the game. In the financial literature these ‘weak players’ are known as ‘noise (or ‘uninformed’) traders.’ Noise makes trading in financial markets possible, and thus allows us to observe prices for financial assets. But noise also causes markets to be somewhat inefficient.

Imagine a world with no noise traders, no information costs, no trading costs –  an efficient market, a market in which it would be irrational to place any trades, a market without traders, a strange kind of world. So the Efficient Market hypothesis in its strictest form cannot be true. So it is possible in principle to beat the market. How might we do this? By a ‘technical’ strategy which uses information contained in past and present prices or odds. Or by a ‘fundamental’ strategy which uses information about real variables, such as form. Or by some combination of these. Those practical matters can be examined at another time. Here we are looking exclusively at whether markets are informationally inefficient as a matter of principle, in a world of positive information costs, or indeed transaction costs, and we can conclude that the answer is Yes.

There is another systematic reason why markets might be inefficient in a broader sense, and that is the existence of asymmetric information. A notable case of this is called ‘adverse selection’, which refers to a situation in which the buyer or seller of a product knows something about the product quality or condition that the other party does not know, allowing them to have a better estimate of what the true cost of the product should be. This can lead to the breakdown of a market in which it exists. George Akerlof’s seminal article (‘The Market for Lemons’), published in 1970 in the Quarterly Journal of Economics, which examined the problem of adverse selection on the market for used cars has important implications for any market characterised by adverse selection.

Here is the problem. If Mr. Smith wants to SELL me his horse, do I really WANT to buy it? It’s a question as old as markets and horses have existed, but it was for many, many years, one of the unspoken questions of economics. So how do we solve this paradox? For most of the history of economics, the answer was quite simple. Simply assume perfect markets and perfect information, so the horse buyer would know everything about the horse, and so would the seller, and in those cases where the horse is worth more to the buyer than the seller, both can strike a mutually beneficial deal. There’s a term for this: ‘gains from trade’.

In the real world, the person selling the horse is likely to know rather more about it than the potential purchaser. This is called ‘asymmetric information’, and the buyer is facing what is called an ‘adverse selection’ problem, as he has adverse information relative to the seller. Akerlof had become intrigued by the way in which economists were limited by their assumption of well-functioning markets characterised by perfect information. For example, the conventional wisdom was that unemployment was simply caused by money wages adjusting too slowly to changes in the supply and demand for labour. This was the so-called ‘neo-classical synthesis’ and it assumed classic markets, albeit they could be a bit slow to work.

At the same time, economists had come to doubt that changes in the availability of capital and labour could in themselves explain economic growth. The role of education was called upon as a sort of magic bullet to explain why an economy grew as fast as it did. But how can we distinguish the impact on productivity of the education itself from the extent to which education simply helped grade people? The idea here is that more able people will tend on average to seek out more education. So how far does education contribute to growth, and how far is it simply a signal and a screen for employers? In the real world, of course, these signals could be useful because employers are like the horse buyers – they know less about the potential employees than the employees know about themselves, the classic adverse selection problem.

Akerlof turned to the used car market for the answer, not least because at the time a major factor in the business cycle was the big fluctuation in sales of new cars. Just like in the market for horses, the first thing a potential used car buyer is likely to ask is “Why should I WANT to buy that used car if he wants so much to SELL it to me”. The suspicion is that the car is what Americans call a ‘lemon’, a sub-standard pick of the crop. Owners of better quality used cars, called ‘plums’, are much less likely to want to sell.

Now let’s say that you’re willing to spend £10,000 on a plum but only £5,000 on a lemon. In such a case, the best price you’d be willing to pay is about £7,500, and only then if you thought there was an equal chance of a lemon and a plum. At this price, though, sellers of the plums will tend to back out, but sellers of the troublesome lemons will be very happy to accept your offer.

But as a buyer you know this, so will not be willing to pay £7,500 for what is very likely to be a lemon. The prices that will be offered in this scenario may well spiral down to £5,000 and only the worst used cars will be bought and sold. The bad lemons have effectively driven out the good plums, and buyers will start buying new cars instead of plums. Just as with horses, asymmetric and imperfect information in the used car market has the potential, therefore, to severely compromise its effective operation.

We can assume that the demand for used cars depends most strongly on two variables – the price of the car and the average quality of used cars traded. Both the supply of used cars and the average quality will depend upon the price. In equilibrium, the supply equals the demand for the given average quality. As the price declines, normally the quality will also fall. And it’s quite possible that no cars will be traded at any price.

This same idea shows the problem of medical insurance. In a free market for medical insurance, people above a certain age, for example, will have great difficulty in buying medical insurance. So why doesn’t the price rise to match the risk? The answer is that as the price level rises the people who insure themselves will be those who are increasingly certain that they will need the insurance. In consequence, the average medical condition of insurance applicants deteriorates as the price level rises – such that no insurance sales [for these age groups] may take place at any price. This is strictly analogous to the car case, where the average quality of used cars supplied fell with a corresponding fall in the price level. The principle of ‘adverse selection’ is potentially present in all lines of insurance. Adverse selection can arise whenever those seeking insurance have freedom to buy or not to buy, to choose the insurance plan, and to continue or discontinue as a policy holder.

There are ways to counteract the effects of quality uncertainty, such as guarantees on consumer durables. Brand names perform a complementary function. Brand names not only indicate quality but also give the consumer a means of retaliation if the quality does not meet expectations. Chains – such as hotel chains or restaurant chains – are similar to brand names. Licensing practices also reduce quality uncertainty. And education and labour markets themselves have their own ‘brand names.’

So one of the big problems that confront markets is the fact that some of the participants often don’t know certain things that others in the market do know.  This includes the market for most consumer durables, virtually all jobs markets, many financial markets, etc. In these cases, one of the roles of economics is to ask what system of incentives is most likely to address this problem of imperfect and asymmetric information. In economics, signalling is the idea that one party (termed the agent) credibly conveys some information about itself to another party (the principal). Signals should be distinguished from what have been called ‘indices’ ( a term coined by Robert Jervis in his 1968 PhD thesis). Indices are attributes over which one has no control. Think of these as generally unalterable attributes of something or someone. Signals are things that are visible and that are in part designed to communicate. In a sense, they are alterable attributes. So employees send a signal about their ability level to the employer by acquiring certain education credentials. The informational value of the credential comes from the fact that the employer assumes it is positively correlated with having greater ability.

Education credentials can be used as a signal to the firm, indicating a certain level of ability that the individual may possess; thereby narrowing the informational gap. In a seminal article on signalling, published in 1973 by Michael Spence, he proposes the key assumption that good-type employees pay less for one unit of education than bad-type employees. In Spence’s model it is optimal for the higher ability person to obtain the credential (the observable signal) but not for the lower ability individual. The premise for the model is that a person of high ability has a lower cost for obtaining a given level of education than does a person of lower ability.  Cost can be in terms of tuition costs, or intangible costs, such as stress and time and effort in obtaining the qualification. Thus, if both individuals act rationally it is optimal for the higher ability person to obtain the qualification but not for the lower ability person so long as the employers respond to the signal correctly. This will result in the workers self-sorting into the two groups. For this to work, it must be excessively costly, or impossible, to project a false image. The basic argument follows from the intuition that a behaviour that costs nothing can be equally well taken by anyone and so provides no information. It follows that perceivers should focus on behaviour which is costly to undertake. Signalling is an action by a party with good information that is confined to situations of asymmetric information.

The concept of screening should be distinguished from signalling, the latter implying that the informed agent moves first. When there is asymmetric information in the market, screening can involve incentives that encourage the better informed to self-select or self-reveal.

Joseph Stiglitz pioneered the theory of screening, examining how a less informed party can induce the other party to reveal their information. They can provide a menu of choices in such a way that the optimal choice of the other party depends on their private information. For example, a theme park might offer a menu of gold and silver tickets, where the more expensive gold ticket allows the customer to avoid the queue at rides. This will induce the customers to self-sort and reveal genuine information as to the value they place on their time and their desire to avoid the queues.

So can markets be efficient? In the strictest informational sense, the answer is No. But there are ways in which they can be made more efficient in the broader sense of the term than they would be in their natural state.

Reading and Links

Missing Markets: Insurance and Lemons. CORE. https://core-econ.org/the-economy/book/text/12.html#126-missing-markets-insurance-and-lemons

The Efficient Market Hypothesis and Its Critics. Burton Malkiel. 2003.

Click to access Efficient%20Market%20Hypothesis%20and%20its%20Critics%20-%20Malkiel.pdf

Akerlof, G. (1970), The Market for Lemons: Quality, Uncertainty and the Market Mechanism. Quarterly Journal of Economics. 84:488-500.

Grossman, S.J. and Stiglitz, J. (1980), The Impossibility of Informationally Efficient Markets, American Economic Review, June, 393-408.

Jervis, R. Signaling and Perception, in Kristen Monroe, ed., Political Psychology (Earlbaum, 2002).

Spence, M. (1973). “Job Market Signaling”. Quarterly Journal of Economics (The Quarterly Journal of Economics, 87 (3): 355–374.

Joseph E. Stiglitz, 1975. “The Theory of ‘Screening’, Education, and the Distribution of Income,” American Economic Review, 65(3), pp. 283–300.

Joseph E. Stiglitz, 1981. “Information and the Change in the Paradigm of Economics”, Nobel Prize Lecture, December 8.

A. Michael Spence, 1981. “Signaling in Retrospect and the Informational Structure of Markets”, Nobel Prize Lecture, December 8.

George A. Akerlof, “Behavioral Macroeconomics and Macroeconomic Behavior”, Nobel Prize Lecture, December 8.