Question

What is the difference between market efficiency as conceived by financial economists, such as Eugene
Fama (inventor of the efficient markets hypothesis], versus economic efficiency as defined by economists
such as Adam Smith inventor of the "invisible hand"? (10 marks)

Answer 1

Efficient market hypothesis :-

According to Eugene Fama , At any given point the actual price of security already reflects the effects of information based on events that have :-

1) Already occurred

2) Are occurring

3) Expected to be occurred

The financial asset prices reflects the best knowledge of past , present and anticipations of the future .

1) When there is an unanticipated favourable event ,prices adjust quickly for efficient markets and keep drifting upwards for inefficient markets .

2) Similarly for unanticipated unfavorable event ,prices adjust or keep drifting downwards for some time .

3) The anticipated event is followed by upward drift movement initially and stabilization for efficient markets subsequently.

4) For anticipated unfavorable event the drift is downwards .

Invisible hand :-

According to Adam Smith each participant in Competition market is led by an invisible hand to promote an end which was not part of his intention.

The invisible hand that guides buyers and sellers in following ways :-

1) Consumers buys until Marginal Benefit = Price

2) Producers supply until Marginal Cost = Price

3) Thus consumer and producer face same price

The invisible hand is a market allocation system in which resources are allocated through the independent decision of buyers and freely moving prices .

Now in the above graph we see that subsidy does not increase value because of scarcity of resources . The production of one commodity requires resources to be drawn from other commodity.

Thus the main difference between both the theories is that in efficient market hypothesis. The reason for stabilisation of prices is the tendency of reflection of events in the value of prices in efficient markets while the invisible hand theory focuses more on the stability of prices because of scarcity of resources.