The Social Value of Information Uncertainty
48 Pages Posted: 28 Feb 2019 Last revised: 1 Jun 2021
Date Written: February 12, 2019
We consider probabilistic information acquisition in the canonical Grossman-Stiglitz pure-exchange economy. In contrast to the previous literature, we show that costly information acquisition in financial markets can be welfare-improving. In particular, when risk-sharing incentives are weak and information quality is moderate, the welfare benefit can be very significant for speculators who provide liquidity. We show that marginal welfare can be decomposed into a positive probability-choice effect and a negative informed-trading effect. When the latter effect dominates, which occurs when risk-sharing incentives are strong, only the no-information equilibrium is Pareto-optimal. Otherwise, heterogenous endowment shocks and the Hirshleifer effect allow for a continuum of Pareto optimal equilibria. This suggests that regulatory efforts to alter the amount of informed trading may be unnecessary.
Keywords: social welfare, information acquisition uncertainty, probabilistic choices, rational expectations equilibrium
JEL Classification: D82, G12, G14
Suggested Citation: Suggested Citation