The Grossman-Stiglitz paradox

17 Jun, 2014 at 13:27 | Posted in Economics | 3 Comments

In general the price system does not reveal all the information about “the true value” of the risky asset …

tumblr_n6vk0tAVwh1rlnhn7o1_500The only way informed traders can earn a return on their activity of information gathering, is if they can use their information to take positions in the market which are “better” than the positions of uninformed traders. “Efficient Markets” theorists have claimed that “at any time prices fully reflect all available information” … If this were so then informed traders could not earn a return on their information.

When the efficient markets hypothesis is true and information is costly, competitive markets break down … As soon as the assumptions of the conventional perfect capital markets model are modified to allow even a slight amount of information imperfection and a slight cost of information, the traditional theory becomes untenable. There cannot be as many securities as states of nature. For if there were, competitive equilibrium would not exist …

Because information is costly, prices cannot perfectly reflect the information which is available, since if it did, those who spent resources to obtain it would receive no compensation. There is a fundamental conflict between the efficiency with which markets spread information and the incentives to acquire information.

Sanford Grossman & Joseph Stiglitz

Here is my own take on the paradox (only in Swedish, sorry).


  1. Qualtitative statements do not suffice, you actually must have worked and calculated through Stiglitz’ papers to understand that slight information asymmetries lead to large welfare losses. His work in asymmetric information is basically a robustness check of Arrow-Debreu.

    I find it strange that so few macroeconomists actually care about Stiglitz’ work. If you wanna do microfounded macro you better start with Stiglitzian ingriedients. Certainly beats Calvo contracts by miles.

  2. To comment on Lars opinions of the Grossman-Stiglitz paradox is that it is not enough to show that the assumption is unrealistic, because that is alright as long as the consequence of small differences to the suggested theory do not change the end result. I didn’t see any clear reason in your text Lars to expect that this assumption leads to great problems. If you for instance examine the performance of Lehman brothers stock, close to the time when Lehman went bankrupt, it seems to roughly follow the theory of perfect information.

    • “alright as long as the consequence of small differences to the suggested theory do not change the end result”

      As I already pointed out, the literature on asymmetric information showed that this is wrong: small information asymmetries do lead to large incentive problems and welfare reductions.

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