The efficient market

1. Describe the efficient market hypothesis and give a piece of evidence consistent with this theory.

The Efficient Market Hypothesis is and investment theory that claims it is impossible to predict and beat the stock market through fundamental or technical analysis. The reasoning behind this is that share prices always reflect all available information and instantly change when new information is available. Buyers of securities are assuming that the value is more than that which they are paying, whereas sellers are assuming that the securities are worth less than what they are selling for. But if markets are efficient and current prices reflect all information, the only way to consistently outperform the stock market is through luck rather than skill.

The Efficient Market Hypothesis has three forms of varying degrees. The ‘Weak’ form is when past market prices and data have been fully reflected in securities prices (i.e. technical analysis is useless). The ‘Semi-strong’ form is when all publicly available information is accounted for is the prices (i.e. fundamental analysis is useless). The ‘Strong’ form is when all information is accounted for (i.e. insider information is useless.)

Auto-correlation is a method used to test the weak from of EMH. This method takes price movements over one period of time and compares it to that of previous prices. Tests have found that there is usually no significant level of auto-correlation except in some portfolios of small shares (which may be because they are traded less frequently.)

The Random Walk Hypothesis is similar to EMH and is used to explain that stock prices are completely random due to the efficiency of the market and was tested by flipping a coin. Returns from those that attempted to predict the market were, on average, the same as those who picked a stock at random.

2. The cleaning service firm CleanAll plc increased its worker’s wages by 4%, and it experienced an increase in its profits. How can this have happened?

The basic theory to explain this is efficiency wages. This theory states that by paying above the market wage, the best employees in the industry are attracted to the firm. This may mean the more efficient for example and so by then employing these workers, the output of the firm will increase leading to higher profits. The higher wages will act as an incentive for the workers not to slack off for fear of losing their jobs and having to move to another firm where a lower wage is paid. The risk of the better workers moving to other firms to work is also reduced.

In the case of CleanAll, the higher wage rate has increased productivity meaning that output is higher and so profits are increased.

3. Does an increase in savings lead to a higher standard of living? Why? Why might a politician prefer not try to introduce measures to increase the rate of saving?

Yes, an increase in savings would lead to a higher standard of living, but only for a while. This is because more capital can be accumulated when there is a higher savings rate. However, over time the benefits from the additional capital reduces over time and so growth slows due to diminishing returns. In the long run, the higher saving rate may lead to a higher level of productivity and standard of living but this point of long run may take a while to reach.

Politicians will not want such a high savings rate as it may affect aggregate demand too much and therefore effect the growth in a negative way. Consumption and investment may both fall as people do not want to spend money as the return from saving money is better.