On the Impossibility of Informationally Efficient Markets

If competitive equilibrium is defined as a situation in which prices are such that all arbitrage profits are eliminated, is it possible that a competitive economy always be in equilibrium? Clearly not, for then those who arbitrage make no (private) return from their (privately) costly activity. Hence the assumptions that all markets, including that for information, are always in equilibrium and always perfectly arbitraged are inconsistent when arbitrage is costly. We propose here a model in which there is an equilibrium degree of disequilibrium: prices reflect the information of informed individuals (arbitrageurs) but only partially, so that those who expend resources to obtain information do receive compensation. How informative the price system is depends on the number of individuals who are informed; but the number of individuals who are informed is itself an endogenous variable in the model. The model is the simplest one in which prices perform a well-articulated role in conveying information from the informed to the uninformed. When informed individuals observe information that the return to a security is going to be high, they bid its price up, and conversely when they observe information that the return is going to be low. Thus the price system makes publicly available the information obtained by informed individuals to the uniformed. In general, however, it does this imperfectly; this is perhaps lucky, for were it to do it perfectly, an equilibrium would not exist. In the introduction, we shall discuss the general methodology and present some con-