Endogenous Public Information and Welfare in Market Games

Abstract

This paper performs a welfare analysis of markets with private information in which agents can condition on noisy prices in the rational expectations tradition. Pricecontingent strategies introduce two externalities in the use of private information: a payoff (pecuniary) externality related to aggregate volatility and a learning externality. The impact of the first depends on whether competition is of the strategic substitutes or complements variety and the second induces agents to put too little weight on private information. We find that with strategic substitutes and when the learning externality is not very strong agents put too much weight on private information and prices are too informative. This will happen in the normal case where the allocational role of price prevails over its informational role. Under strategic complementarity there is always under-reliance on private information. The welfare loss at the market solution may be increasing in the precision of private information. The analysis provides insights into optimal business cycle policy and a rationale for a Tobin-like tax for speculators in financial markets.