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Price discovery is the process by which new information is incorporated into prices through trading. Efficient markets require that prices quickly and accurately reflect all available information. However, frictions (transactions costs, information asymmetry, limits to arbitrage) can slow discovery and create mispricing opportunities.
The Efficient Market Hypothesis (EMH) gives you the benchmark: in an efficient market, prices fully reflect all available information. But the EMH is a description of an *endpoint*, not a mechanism. Price discovery is the actual process — the sequence of trades, bids, asks, and order flows through which new information gets embedded in prices. Understanding this mechanism is essential because real markets are never at the efficient equilibrium; they're always moving toward it, and how fast they move depends on market structure and frictions.
The core mechanism works through informed traders. Suppose a company just reported better-than-expected earnings and you know the news before most market participants. You buy aggressively. As you buy, you push the price up, signaling to other traders that someone thinks the stock is underpriced. Others observe the price movement and the order flow, update their own beliefs, and buy too. This cascading updating continues until the price reaches the level that fully reflects the earnings surprise. No individual trader necessarily knows the "right" price — it emerges from the aggregation of private information through trading. This is what Hayek called the price system's information-aggregating function, and it's the microstructure mechanism behind the EMH.
The bid-ask spread you studied is central to how quickly discovery happens. Market makers stand ready to buy at the bid and sell at the ask, earning the spread as compensation for the risk of trading with informed counterparties. When an informed trader hits a market maker's ask, the market maker worries they're on the wrong side of an information-driven trade and revises their quotes upward. This adverse selection drives prices toward their fundamental value even before the information becomes public. Narrow spreads (liquid markets) speed discovery; wide spreads (illiquid or opaque markets) slow it. This is why price discovery in exchange-traded derivatives often leads price discovery in the underlying asset — derivatives markets can be more liquid for certain participants.
Limits to arbitrage explain why mispricings can persist even when informed traders exist. Classical theory says any deviation from fundamental value gets instantly corrected by arbitrageurs. But correcting a mispricing requires capital, and that capital faces risk: the mispricing can get worse before it gets better. A trader who is certain a stock is undervalued but runs out of capital (or patience with their investors) before the price corrects earns nothing from being right. This is why transaction costs, short-selling constraints, and funding risk create a band around fundamental value within which prices can wander. Price discovery is efficient in the limit but can be sluggish or incomplete in the short run, especially in stressed markets where arbitrage capital is scarce precisely when mispricings are largest.