Working Paper: NBER ID: w0678
Authors: Joseph E. Stiglitz
Abstract: This paper provides the foundations of a general theory of information and the capital market. We show that in a pure gambling market, even with asymmetric information, there cannot exist an equilibrium with trade with rational individuals. We argue that although a pure exchange stock market is not a pure gambling market, most of the trade on the stock market arises from irrationality on the part of some investors and the rational response on the part of other investors to take advantage of that irrationality. We show that the private returns to information acquisition and dissemination differ markedly from social returns and as a result the market equilibrium is not a (constrained) Pareto optimum. Moreover, we show how firms' actions, e.g. the fraction of shares retained by the original entrepreneurs, the debt equity ratio, and the level of investment, may convey information about firm characteristics. This in turn affects the behavior of firms. As a result, the original owners of firms will be incompletely diversified, firms will not take actions which maximize their stock market value, and, in particular, they may behave in a risk averse manner, paying attention to own risk (which traditional theory suggests that the only risk firms should care about is the correlation with the market).
Keywords: Information; Capital Markets; Market Efficiency; Asymmetric Information
JEL Codes: D82; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Rational expectations (D84) | No trade in pure gambling market (H27) |
| Irrational behavior by some investors (G41) | Opportunities for rational investors to profit (G11) |
| Firm actions (retaining shares, adjusting capital structure) (G34) | Market perceptions and investor decisions (G11) |
| Information conveyed by firm actions (L20) | Market behavior (D40) |
| Private returns to information acquisition and dissemination (D83) | Market equilibria (D53) |