Prices and knowledge: A market-process perspective

34 Prices and knowledgeAn example. The two cases considered by Grossman and Stiglitzcan perhaps be made clearer by means of an example they provide(Grossman and Stiglitz 1976:246–7). 12 Suppose there is a riskysecurity with an uncertain return but that some information about thisreturn can be obtained at a cost. The demand for this security byinformed traders will then depend on its current price and on theiracquired information about its return. The demand by uninformedindividuals will depend only on its price. The example assumes thereis a fixed stock of the security, and no other source of changes in itsprice. Uninformed individuals will then be able to infer costlesslyfrom, say, a higher price that there is information (possessed byinformed individuals) about a higher return. This price system,Grossman and Stiglitz argue, conveys information from informed touninformed individuals.The situation with a fully informative price is not anequilibrium because no trader finds it necessary to spendresources seeking information. But then the price will not beinformative! The situation with uninformative prices is not anequilibrium either: in this situation it is profitable for any trader toseek information about the return on the security. Each traderthinks this will give him an advantage over others because hebelieves his informed activity will not modify the price andconvey his information to them. However, when many tradersbehave in this way the price starts to reflect their information,making their costly information-gathering unattractive, as at thebeginning of the example. Therefore no equilibrium exists.The example is then modified slightly by introducing somerandomness, for example, in the stock of the risky security. Then itsprice may be higher because the informed individuals haveincreased their demand in the expectation of a higher return, orbecause the supply has fallen. ‘The price system conveys someinformation, but does not transmit all the information from theinformed to the uninformed: on average, when the price is high, thereturn is high…but the price is a noisy signal’ (Grossman andStiglitz 1976:247; emphasis in original). It is not the same toobserve the price as to obtain information about the return on thesecurity. Under these circumstances there is a return to theinformation-gathering activity, and there may exist an equilibriumin which an optimal amount takes place. (Grossman and Stiglitzpresent a case in which there is an optimal fraction of thepopulation becoming informed.)