Information and Capital Markets
AbstractThis paper provides the foundations of a general theory of information and the capital market. We show that in a pure gambling market, even with asymmetric information, there cannot exist an equilibrium with trade with rational individuals. We argue that although a pure exchange stock market is not a pure gambling market, most of the trade on the stock market arises from irrationality on the part of some investors and the rational response on the part of other investors to take advantage of that irrationality. We show that the private returns to information acquisition and dissemination differ markedly from social returns and as a result the market equilibrium is not a (constrained) Pareto optimum. Moreover, we show how firms' actions, e.g. the fraction of shares retained by the original entrepreneurs, the debt equity ratio, and the level of investment, may convey information about firm characteristics. This in turn affects the behavior of firms. As a result, the original owners of firms will be incompletely diversified, firms will not take actions which maximize their stock market value, and, in particular, they may behave in a risk averse manner, paying attention to own risk (which traditional theory suggests that the only risk firms should care about is the correlation with the market).
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Bibliographic InfoPaper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 0678.
Date of creation: May 1981
Date of revision:
Publication status: published as Stiglitz, Joseph E. "Information and Capital Markets." In Financial Economics: Essays in Honor of Paul Cootner, ed. W.F. Sharpe and C.M. Cootner, pp. 118-158. New Jersey: Prentice-Hall, 1982.
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