Market efficiency represents the degree of the relationship between the prices of commodities or items in a particular market to the information available in the market. Usually, an efficient market is one where the prices reflect all the available information in the market and do not have any inefficiencies.
An efficient market is a theoretical concept in which market participants can make decisions without having to factor or compensate for unavailable information. Therefore, all commodities in an efficient market will always represent the latest and actual prices. Hence, these commodities are not undervalued or overvalued.
What are some conditions for an efficient market?
Apart from all information being available, there are other assumptions that the efficient market makes. For example, the concept assumes that there are no transaction costs associated with buying and selling commodities. Similarly, it believes that there is a large number of customers and suppliers that do not have the power to manipulate or dominate the market.
Furthermore, an efficient market assumes that all products or services sold by all the suppliers within the market are homogeneous or identical. For newcomers or competition, an efficient market believes there are no barriers to entry or exit. In short, the concept assumes new businesses can enter the market and offer their products to customers without having to face any obstacles.
Why is market efficiency important?
Market efficiency does not exist anywhere in the world. However, that does not mean the concept is futile. First of all, market efficiency is a crucial part of many models or calculations. In the absence of the assumptions made by market efficiency, many of these models fail to work. These models are a critical part of the decision-making process of investors and companies around the globe.
Furthermore, market efficiency creates a level ground for investors to make decisions. Similarly, it also eliminates the possibility of investors exploiting the price of different commodities to make a profit. Overall, market efficiency allows investors to make sensible choices. Likewise, it also helps market participants to benefit from uniform prices.
What are the forms of market efficiency?
While market efficiency may never come true, there are several degrees to which market efficiency may exist. These include the following.
Strong market efficiency is when all the assumptions of an efficient market apply. It represents the strongest or purest form of market efficiency. The strong form of market efficiency is the most difficult to attain.
Semi-strong efficiency represents a market where the prices of commodities in a market absorb the latest public information available. Therefore, it does not allow investors to benefit from exploiting the information. It also disallows investors to benefit from using fundamental or technical analysis tools.
Weak efficiency represents a market where the prices of commodities reflect the historical information available. Therefore, it does not consider the latest news about the stock. It allows investors to use fundamental analysis to benefit from price differences but does not allow for technical analysis.
Market efficiency is a concept that represents a market where commodity prices reflect the latest information available. However, in practice, it may not be achievable. Despite that, market efficiency is a vital concept for the various reasons discussed above.