Do stock markets reflect the model of perfect competition?

Perfect competition is a market structure with the following features

  • Many buyers and sellers – 1000s of firms.
  • Freedom of entry and exit into the market
  • Homogenous good
  • Perfect information

In a way, stock markets are an example of perfect competition.

  • There are hundreds of buyers and sellers. When buying shares you can choose from innumerable different brokers.
  • All brokers have, in theory, equal access to regularly updated information.
  • Consumers can easily check and compare the different prices of brokers. The internet and modern technology has helped to reduce the profit margin of brokers.
  • Shares in one company are homogenous. It doesn’t matter which broker you buy shares from
  • There are few barriers to entry and exit; anybody can buy shares if they have enough money. There may be some barriers to entry in that you need to meet regulations laid down by the stock market. Also, you may need to invest in office and advertising to set up business. But, the barriers to entre are non-insurmountable.
  • We can assume most stock market traders are rational people who seek to maximise their profits.

But despite this, stock markets tend to behave erratically with large swings in share prices. This suggests that the market is not perfectly competitive or least does not always fit the model of efficient market hypothesis.

The efficient market hypothesis is the argument that with many rational agents. The price of stocks will always reflect the ‘true’ market value because if it is overvalued, it becomes profitable to sell. If it is undervalued, it becomes profitable to buy.

But, if investors have perfect information how do we explain stock market crashes?

Issues with the stock market

1. Herding behaviour. ‘Wisdom of the Crowds’

It is often assumed that if markets are rising there must be a good reason for the rise in prices. If professional investors are buying dot com shares why should we not? Therefore, it is often the case that people get caught up in the prevailing mood of the market.  When prices rise this encourages other people to buy. When prices fall the opposite occurs and investors seek to sell before prices fall anymore. Chartists argue that you can make money and shares by carefully studying trends in share price movements.

2. Information is poor

The other assumption is that investors have accurate information. Firstly, it is difficult to be completely aware of the current profits of a company. But the key for share prices are forecasts for the future. People buy shares on expectations of future profits. However, there are many factors that can make it difficult to accurately predict profit growth. Often profit forecasts are extrapolated by looking at past profit trends. However, just because a company has had profit growth of 20% for the past 5 years, there is no guarantee it will continue to have similar profit growth. Also, some traders may gain ‘inside information.’ For example, they may learn that the company is not as profitable as outer appearances. “Insider trading” is illegal but often hard to prove.

  • Some times, analysts don’t have time to investigate smaller companies and so they may miss companies with great potential.

Importance of Stock Market on the Economy

The stock market is an important source of company finance, which offers greater flexibility than borrowing from banks. Companies can list on the stock market and sell their shares. This enables them to gain finance to invest. For example, a stock market flotation was very important for Eurotunnel to gain the necessary funds to invest in the long term project of building the channel tunnel.

How The Stock Market Affects the Rest of the Economy

A fall in share prices can adversely affect the wider economy. If share prices fall, investors will see a fall in wealth, this may make them more reluctant to spend. This can cause a fall in economic growth. However, the impact of this is relatively limited. Most people who buy shares don’t rely on this invested money for consumption. It would need a prolonged fall in share prices to change consumer spending. For example, after the 1987 stock market crash (share prices fell 25% in a week), it did not cause a fall in economic growth.

See more: How the Stock Market effects the economy

Factors Affecting the Stock Market

Share prices can rise or fall depending on a number of factors

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