Welfare Costs of Informed Trade
AFA 2016 San Francisco Meetings
44 Pages Posted: 23 Aug 2016
Date Written: July 7, 2016
We examine the welfare costs of informed trade in a new Glosten-Milgrom type model with elastic uninformed trade. Welfare losses occur when uninformed agents choose not to trade because their idiosyncratic valuation lies within the bid-ask spread. Informed trade causes wider spreads initially, but narrower spreads later because information is reflected in prices faster. For sufficiently long lived information, the benefits of narrow spreads later outweigh the wider initial spreads such that the average spread and total welfare loss are mainly decreasing in the amount of informed trade. For short-lived information, this tradeoff does not materialize and spreads and welfare losses are increasing in informed trade. Our findings suggest that regulation of information and informed trade should consider the horizon of private information.
Keywords: market microstructure, welfare, liquidity, informed trading, insider trading
JEL Classification: G14, K22
Suggested Citation: Suggested Citation