LSE Financial Markets Group Working Paper No. 381
45 Pages Posted: 28 Jul 2001
Date Written: June 2001
In this paper we provide a characterization of the welfare properties of rational expectations equilibria of economies in which, prior to trading, agents have some information over the realization of uncertainty. We study a model with asymmetrically informed agents, treating symmetric information as a limiting case. Trade takes place in asset markets that may or may not be complete. We show that equilibria are characterized by two forms of inefficiency, price inefficiency and spanning inefficiency, and that generically both of them are present. Price inefficiency arises whenever equilibrium prices reveal some information. It formalizes and generalizes the so-called Hirshleifer effect, by showing that generically an interim Pareto improvement is possible even conditional on the information that is available to agents in equilibrium; the primary source of the inefficiency is a pecuniary externality. Spanning inefficiency, on the other hand, arises if prices are not fully revealing and markets are incomplete relative to the uncertainty faced by agents in equilibrium. In this case, an ex-post improvement can generically be implemented by providing agents with more information, thus expanding their risk-sharing opportunities and reducing informational asymmetries, even though this additional information restricts the set of allocations that are incentive compatible and individually rational.
Keywords: Rational Expectations Equilibrium, Asymmetric Information, Incomplete Markets
JEL Classification: D52, D60, D82
Suggested Citation: Suggested Citation
Rahi, Rohit and Gottardi, Piero, Efficiency Properties of Rational Expectations Equilibria with Asymmetric Information (June 2001). LSE Financial Markets Group Working Paper No. 381. Available at SSRN: https://ssrn.com/abstract=277371 or http://dx.doi.org/10.2139/ssrn.277371