A security market that functions effectively provides society with two benefits. First, it allocates scarce resources – in this case, investors’ funds – to those firms that will make the best economics use of them. That is, a well-functioning security market helps supplies of funds find those who demand funds and will make the best use of them. For example, consider two firms that both need several hundred million dollars for investment. Firm A can make 20% on this investment, whereas Firm B can make only 15% (assume the risk is similar). Suppose there is a limited supply of funds. If the market is efficient and all information is available to potential investors, these investors will be more inclined to buy Stock A that Stock B. Therefore, more money will be allocated to the more profitable firm. Second, a well-functioning security market will reduce the cost of moving in and out of securities, which in turn enlarges the set of investor willing to supply funds; hence, firms will have more funds to invest in production.

    A well-functioning security market also benefits buyers and sellers in three ways; by making information available, by establishing prices, and by increasing the liquidity of the assets being bought or sold.

Information Availability

    Buyers and sellers must be able to communicate with each other and have access to timely and accurate information in a well-functioning security market. Notice that neither criterion requires the buyer and seller (or their representatives) to meet at a physical location.

Price Setting

    In a well-functioning security market, prices should reflect all the available information. That is, the market price should not misrepresent known information. Price setting has its costs, and for a market to function well, these costs should be minimal. We call these costs of price setting execution costs, and they include transaction costs, market impact effects, and inaccurate price discovery.

    Transaction costs include the costs related to communication systems, the costs related to the party who is willing to buy or sell the securities, and any other fees or expense. When transaction costs are low, more investors are willing to participate in the market.

    Market impact effects are price changes that result from buying or selling pressure. For example, a stock may be quoted at $100, but if it has fall to $90 for an investor to be able to sell 10,000 share, this market impact effect represent a major cost to the investor.

    Inaccurate price discovery refer to securities trading at prices that do not reflects true value. Clearly, buying a stock that is 10% overpriced will be costly. In a well functioning security market, prices adjust quickly to new information, and securities are correctly priced. If there a lag between the time when information is available and a price change, price discovery will be inaccurate during this period.