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4.3 The Importance of Free Stock Markets

The stock market is a very important institution for the economy for three reasons.

First, because it increases the ability to raise capital. It is a well-known market where people who want to invest in companies can be matched with companies that needs to raise capital. And as the ability to trade shares on a secondary market means that investors can sell their investment if they suffer from liquidity problems or change their assessment of the company they have invested in, that will make them more willing to invest compared to a situation where they couldn’t sell their shares. And the more liquid a stock market is (the greater the number of transactions is), the better it will fulfill that function as it will reduce the problem of slippage,

Secondly, it fulfills an entrepreneurial function and creates a way to calculate for investors and companies where money should be invested. A company does not exist for its own sake, but to create value for its shareholders. If a company cannot use capital in a more efficient way than others then it should distribute them to their shareholders in the form of dividends (or stock repurchases, but they could be seen as a form of dividend) so that they could then reinvest that money in more efficient companies. But how can management know whether it would be best with new investments, purchases of other companies or dividends?

They can know this by looking at stock prices. If the stock price is high, then that means that the cost of capital is low. The company’s operations could thus be expanded without much extra investments from the shareholders. At the same time there is less point in paying out more dividends as it would only slightly increase shareholder wealth while in a more substantial way limiting company expansion. If by contrast the share price is low this would require much greater extra investments from the shareholders to achieve a certain level of expansion, while dividends would produce a much greater boost for shareholders given any limitation of a company’s operations. And quite obviously, the lower the price of a certain company, the more attractive will it be for others to acquire it.


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