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Informational and Allocative Efficiency in Financial Markets with Costly Information

Author

Listed:
  • Arina Nikandrova

    (Department of Economics, Mathematics & Statistics, Birkbeck)

Abstract
Costly information acquisition is introduced into a dynamic trading model of Glosten and Milgrom (1985). The market maker and some traders, called "value traders," value the asset at its fundamental value, which can be either high or low. The remaining traders, called "liquidity traders," have idiosyncratic valuations that are independent of the fundamental. At a cost, each value trader can acquire an informative, but imperfect, signal about the fundamental. In this setting, at equilibrium, each value trader acquires the signal if and only if the uncertainty about the fundamental's value conditional on publicly available information is sufficiently high. Thus, the prices quoted by the market maker are "informationally inefficient," as they do not reveal the value of the fundamental, even in the long-run. Equilibrium amount of information acquisition is either excessive or insufficient relative to the social optimum and results in an inefficient allocation of the asset among the market maker and liquidity traders.

Suggested Citation

  • Arina Nikandrova, 2014. "Informational and Allocative Efficiency in Financial Markets with Costly Information," Birkbeck Working Papers in Economics and Finance 1403, Birkbeck, Department of Economics, Mathematics & Statistics.
    • Handle: RePEc:bbk:bbkefp:1403
    as

    Download full text from publisher

    File URL: https://eprints.bbk.ac.uk/id/eprint/15282/1/15282.pdf
    File Function: First version, 2014
    Download Restriction: no
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    References listed on IDEAS

    as
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    Cited by:

    1. Kendall, Chad, 2018. "The time cost of information in financial markets," Journal of Economic Theory, Elsevier, vol. 176(C), pages 118-157.

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    More about this item

    Keywords

    Sequential Trading; Cost of Information; Endogenous Information Acquisition.;
    All these keywords.

    JEL classification:

    • D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General
    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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