Information and Heterogeneous Beliefs: Cost of Capital, Trading Volume, and Investor Welfare

Abstract

In an incomplete market with heterogeneous prior beliefs, we show public information can have a substantial impact on the ex ante cost of capital, trading volume, and investor welfare. The Pareto efficient public information system is the system enjoying the maximum ex ante cost of capital and the maximum expected abnormal trading volume. Imperfect public information increases the gains-to-trade based on heterogeneously updated posterior beliefs. In an exchange economy, this leads to higher growth in the investors' certainty equivalents and, thus, a higher equilibrium interest rate, whereas the ex ante risk premium is unaffected by the informativeness of the public information system. Similar results are obtained in a production economy, but the impact on the ex ante cost of capital is dampened compared to the exchange economy due to welfare improving reductions in real investments to smooth the investors' certainty equivalents over time.