Stock Market Efficiency and Economic Efficiency: Is There a Connection?

James Dow, Gary Gorton

NBER Working Paper No. 5233
Issued in August 1995
NBER Program(s):Corporate Finance

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 since managers have discretion in determining the level of investment. What is the link between stock price informational efficiency and economic efficiency? We present a model of the stock market in which: (i) managers have discretion in making investments and must be given the right incentives; and (ii) stock market traders may have important information that managers do not have about the value of prospective investment opportunities. In equilibrium, information in stock prices will guide investment decisions because managers will be compensated based on informative stock prices in the future. The stock market indirectly guides investment by transferring two kinds of information: information about investment opportunities and information about managers' past decisions. The fact that stock prices only have an indirect role suggests that the stock market may not be a necessary institution for the efficient allocation of equity. We emphasize this by providing an example of a banking system that performs as well.

download in pdf format
   (649 K)

email paper

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w5233

Published: Journal of Finance, Vol. 52, no. 3 (July 1997): 1087-1129. citation courtesy of

Users who downloaded this paper also downloaded* these:
Schwert w9277 Anomalies and Market Efficiency
Gorton, Huang, and Kang w14944 The Limitations of Stock Market Efficiency: Price Informativeness and CEO Turnover
Bollerslev and Hodrick w4108 Financial Market Efficiency Tests
Lehmann w2533 Fads, Martingales, and Market Efficiency
Blanchard, Rhee, and Summers w3370 The Stock Market, Profit and Investment
NBER Videos

National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email:

Contact Us