Efficiency of Asset Markets with Asymmetric Information
We examine the welfare effects of costly information acquistion in a version of the Grossman-Stiglitz (1980) exchange economy in which all traders are fully rational. We find, as emphasized by Hirschleifer, that information gathering leads the suboptimal risk sharing. Furthermore, information gathering worsens the equilibrium risk-return tradeoff faced by investors. We show that all investors would be better off if the information were not available and that the welfare costs of information gathering are greater when (i) the cost of acquiring information is lower; (ii) the prior return variance of the risky asset is higher; and (iii) the quality of the information is higher. We also show that the relative welfare costs to investors depends on the combination of their endowment and preferences.
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