Market Equilibrium, Efficiency, and the Role of Frictions
Summary
The document distinguishes market equilibrium from market efficiency. Efficiency concerns how quickly available information is reflected in prices, while equilibrium describes a balance between supply and demand. Since liquidity needs can temporarily skew that balance, a market may incorporate information quickly without being in equilibrium at a particular moment.
It also explains that whether equilibrium implies efficiency depends on the assumptions behind the equilibrium. A rational-expectations setting with shared information and suitable preferences may yield efficiency relative to that information. Differences in information, interpretation, preferences, transaction costs, attention, or liquidity can break that implication. The discussion is conceptual rather than empirical: it provides no test of efficiency or method for estimating fair value, and the meaning of efficiency depends on which information set and model assumptions are used.
Key ideas
- Efficiency concerns the incorporation of information into prices, while equilibrium concerns supply-demand balance.
- Short-term liquidity pressures can disturb equilibrium even when information is priced quickly.
- Some idealized rational-expectations equilibria can be efficient relative to their information assumptions.
- Information gaps, preferences, transaction costs, attention, and liquidity frictions can prevent equilibrium from implying efficiency.
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Full text
# What is the difference between market equilibrium and market efficiency? equilibrium implies efficiency? # What is the difference between market equilibrium and market efficiency? equilibrium implies efficiency? The market efficiency hypothesis means securities are traded at their fair price. If the market is at the equilibrium, does it mean the market is efficiency? If equilibrium cannot implies efficiency, why was that? As the equilibrium price should be achieved by supply and demand, why the price is not the fair price? ## Answer by dkhokhlov (score 1) https://quant.stackexchange.com/a/19393 Market is efficient when all available public information gets priced-in relatively fast by market participants. This yields the fair price. Efficiency depends on the speed of the information dissemination. Equilibrium is a balance between supply and demand, which can be skewed by short term liquidity issues. So market can be efficient and not in equilibrium at the same time. ## Answer by Neeraj (score 1) https://quant.stackexchange.com/a/19395 Read paper written by Malkiel, "The Efficient Market Hypothesis and Its Critics". It is wonderful paper on EMH. http://eml.berkeley.edu/~craine/EconH195/Fall_14/webpage/Malkiel_Efficient%20Mkts.pdf It will help you to gain conceptual clarity in EMH. ## Answer by pbr142 (score 0) https://quant.stackexchange.com/a/19420 The answer to your question depends on the type of equilibrium. In a perfect information rational expectations equilibrium with preferences that assume that agents always prefer more money to less, the equilibrium is efficient with respect to the information. If you introduce biases in preferences or different information sets (differing ability to interpret information, different access to information, etc.) then an equilibrium does not have to be efficient. This is mainly due to the fact that it is not quite obvious with respect to which information prices should be efficient. Also, differing transaction costs or differences in attention to markets, liquidity effects, sun spots, and other market frictions often result in models in which equilibria do not (necessarily) imply efficiency.
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