What it is:
Price efficiency simply refers to whether the price of a security incorporates all the available information about the security.
How it works (Example):
For example, assume that Company XYZ is a public company trading at $15 per share. On Monday, the company released its latest quarterly report, which details information about its operations, margins, and management. The report indicates that Company XYZ intends to acquire Company ABC next quarter and that the acquisition will double the company's bottom line by December.
Price efficiency means that investors and analysts receive this information as soon as it is released and then form new ideas about what the proper price of Company XYZ stock is based on that information and everything else they know about Company XYZ. Some of this information, like reputational information, is not easily quantifiable or tangible, but affects the value of the stock nonetheless. In our example, if Company XYZ's financial performance is better than expected, investors will probably consider Company XYZ stock to be worth more than before the quarterly information came out.
However, if for some reason only a few people had access to an additional piece of Company XYZ information (say, that the acquisition might not actually close until late next year), then price efficiency could go down. Most investors would not be aware of the information and thus may still feel the shares are worth $20. But some investors who are privy to the acquisition delay may have an entirely different idea of the value of Company XYZ shares (and an unfair trading advantage). The price of Company XYZ wouldn't reflect all of the information available.
Why it Matters:
Price efficiency is a central tenet of modern markets. The faster and more accurate the information, the more useful it is and the more "correct" stock prices are. When information is available to some people but not others, however, the markets become less stable, less transparent, and by definition less efficient.
The efficient market hypothesis, pioneered by Harry Markowitz in 1952, incorporates the idea of price efficiency. By evaluating the expected returns, standard deviation, and the covariances of a set of securities, says the theory, investors can determine which combinations, or portfolios, generate the maximum expected return for various levels of risk. One version of the efficient market hypothesis, the weak form, states that securities prices reflect only publicly available information; the strong form of the efficient market hypothesis states that securities prices reflect both public and insider information.