Revisiting the Efficiency of Competitive Markets: The Incentive to Social Communication

Abstract

This paper revisits the efficiency of a rational expectations equilibrium model of a competitive market from the perspective of the incentive to social communication. The classical result tells us that the equilibrium price perfectly reveals all dispersed information in the market when the supply of the risky asset is a constant, but does not in the environment of random supply. As opposite to this finding, in this paper we show that for some cases the equilibrium price still perfectly reveals all private information of traders when taking into account the incentive to social communication. Specifically, we show that when the communication cost and the difference between traders' signal precisions are small, traders have the incentive to take the average of all traders' demands, that is, the per-capita supply to improve social welfare and every individual trader's welfare. Knowing the supply information reduces the equilibrium price to be a perfect aggregator again even though the supply of the risky asset is stochastic.