STOCK-MARKET EFFICIENCY AND ECONOMIC-EFFICIENCY - IS THERE A CONNECTION

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 sinc e managers have discretion in determining the level of investment. Wha t is the link between stock price informational efficiency and economi c efficiency? We present a model of the stock market in which: (i) man agers have discretion in making investments and must be given the righ t incentives; and (ii) stock market traders may have important informa tion that managers do not have about the value of prospective investme nt opportunities. In equilibrium, information in stock prices will gui de investment decisions because managers will be compensated based on informative stock prices in the future. The stock market indirectly gu ides investment by transferring two kinds of information: information about investment opportunities and information about managers' past de cisions. However, because this role is only indirect, the link between price efficiency and economic efficiency is tenuous. We show that sto ck price efficiency is not sufficient for economic efficiency by showi ng that the model may have another equilibrium in which prices are str ong-form efficient, but investment decisions are suboptimal. We also s uggest that stock market efficiency is not necessary for investment ef ficiency by considering a banking system that can serve as an alternat ive institution for the efficient allocation of investment resources.