Equilibrium in Economy Where Trades Have

Differential Information

August 2005

This paper describes alternative models for a speculative market economy

in which investors have differential information regarding returns of risky
assets. It explains the crucial role played by equilibrium prices to aggre-
gate and transmit information, and how such markets might become over-
informationally efficient. The paper goes on to describe a more complex and
realistic model of a multi-asset economy, and a model where information is
costly to acquire.

1 Introduction
Information relating to prices and expected payoffs helps investors accurately
value the financial assets being traded in the market based, on which they
decide whether to buy, sell or hold on to their investments. But informa-
tion is not homogeneous among investors. The implication and importance
of diversity in information among investors is clearly demonstrated by the
extreme case of insider trading. Insiders have access to special information
which others don’t, and hence have an unfair advantage. Fund managers
also claim to outperform others based on their superior information.
It is now well known that in a speculative economy where traders have
diverse information, the equilibrium price acts as an aggregator and trans-
mitter of information. In the next section we will see how our model confirms
this result, but to get some intuition and see how the models incorporate
this idea, consider an economy which repeats itself. Then, over many cycles
of trading, investors will learn the joint distribution of the price of the asset
and the information of individual investors. In the future when the investors
observe the market price of an asset, they will back-out and extrapolate the
aggregate information held by all investors in the market. When investors
learn from prices as demonstrated above, they are said to have rational
expectations and any equilibrium where agents’ behavior is influenced by
the market price of assets along with their own beliefs is then a Rational
Expectations Equilibrium.

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 Fully Revealing Rational Expectations Equilibrium, equilibrium where
prices symmetrisize information by revealing all the information of the in-
formed to the uninformed, runs into conceptual difficulties. When prices
reveal all the information in the market, individuals realize that information
obtained from these prices is superior to their own. This makes their per-
sonal information redundant and removes any economic incentive to collect
costly information. If all investors think similarly, there is no justification for
any individual to collect information. If nobody is informed, it is profitable
to be informed. Hence fully revealing Rational Expectations Equilibrium is
not stable.
The only way equilibrium will be stable is when there is noise in the equi-
librium price system so that prices cannot reveal all the information of the
informed to the uninformed. In such a Noisy Rational Expectations Equilib-
rium, the investors benefit from information collected by others, which they
estimate from prices, but do not find their personal information redundant.
There is no tension in the optimal use of price and the equilibrium can be
maintained in the market.
The following section describes various models which make our argu-
ments formal and rigorous. We start with a simple model with only one
risky asset and demonstrates how fully revealing rational expectation equi-
librium is not a stable equilibrium. The main problem with such a model,
the absence of any randomness to prevent prices from being fully reveal-
ing, is dealt in subsequent models by treating aggregate supply of assets as
random. Finally we consider more complex models dealing with multi-asset
economy and costly information. For the multi-asset model, it is shown by
means of an example, that results from single-asset models don’t carry into
the multi-asset setting. The paper ends with a list of further readings and
a few potential research directions.

2 The Model
We start by considering a two period economy with T traders and two assets,
one risky and one riskless. Traders invest in the first period and consume
in the second period. Each investor is assumed small so that the trading
activities of any individual does not influence the equilibrium prices in the
economy.
The unit cost of the risky asset is P at time 0 and the time 1 payoff is a
random variable denoted by F̃ . The riskless asset is treated as the numeraire
and it’s time 0 and time 1 price is normalized to 1. Before trading begins,
each investor receives a piece of private information about the time 1 payoff
of the asset. Noise in his information prevents exact knowledge of the payoff.
The precision of the signal received by all the investors is assumed identical.
The signal is given by

2
 Yi = F̃ + i , i = 1...T, (1)
where F̃ is N(0,σf2 ) and i , i = 1, ..., T are i.i.d with distribution N(0,σ2 ). F̃
and the i are independent of each other.
W0i is the endowment of investor i, whose utility has an exponential
form given as Ui (x) = −e−ai x , where ai is the coefficient for risk aversion for
trader i. Therefore investors have constant absolute risk aversion and their
demands are independent of initial endowment.
If θi is the demand for shares of the risky asset, the time 1 wealth of
investor i is
W̃1i = θi (F̃ − P ) + W0i .
Each investor maximizes expected utility of wealth conditional on the signal
received i.e. individual solves

max θi E[U (W̃1i ) | Yi = yi ]. (2)

The conditional distribution of W̃1i given Yi is normal. This gives us the

demand for investor i for the risky asset,

E[F̃ | Yi ] − P
θi = . (3)
ai var(F̃ | Yi )

The assumption that densities are normal allows for closed-form solutions
and ensures that joint and conditional distributions are normal and the
demand function is linear in Yi and P .
From the market clearing condition,
T T
X X E[F̃ | Yi , P ] − P
Z̄ = θi = , (4)
i=1 i=1 ai var(F̃ | Yi , P )

where Z̄ is the total supply of the risky asset.

Grossman (1976) finds a close form solution for the price function for
the model developed above. The price conjecture used is

P = α0 + α1 Ȳ , (5)

where PT
i=1 Yi
Ȳ = .
T
Solving the model gives,

−σf2 Z̄
α0 = PT 1
.
(σ2 + T σf2 ) i=1 ai

3
 T σf2
α1 = .
(σ2 + T σf2 )
The initial endowments do not enter the expression, a consequence of
using the exponential utility function.
On closer inspection, α1 > 0 in the above equations would enable any
trader to calculate Ȳ by observing P . This means that price is aggregat-
ing investor information and transmitting it to everyone. Grossman (1976)
shows estimate of F̃ made by using both Ȳ and Yi is independent of Yi i.e.
Ȳ is a sufficient statistic for Yi . Hence after observing P the investor finds
that the information obtained from prices is of better quality and his own
information is redundant. This eliminates any motivation for individuals to
collect costly information. But when nobody collects any information, there
is nothing for prices to aggregate. Therefore the equilibrium is not stable
and breaks down.
To overcome the limitation of the above model, Grossman (1976) and
Grossman and Stiglitz (1980) suggest that “there is an equilibrium degree
of disequilibrium in the market”. They argue that there has to be noise
in the equilibrium prices so that they do not reveal all the information. In
their paper noise is introduced by taking the aggregate supply of assets as
random. The equilibrium price is now affected by both, changes in supply
of the asset or changes in the quality of information, but investors cannot
distinguish between the two and hence price is not fully revealing. There is
then reward from investing in information and the equilibrium thus obtained
does not suffer from the earlier shortcoming of individuals lacking motivation
to collect information.
To develop such a model, let the endowment of investor i be vi which
is N(0, σv2 ) and independent of F̃ and the i , i = 1...T . The total supply of
asset in the market is now random denoted by
T
X
Z̃ = vi .
i=1

Z̃ is then N(0, T σv2 ). The investors are still expected utility maximizers but
the only information they have about the supply of risky asset in the market
comes from their endowment of the asset. The form of the price function is
taken as
P = α0 + α1 Ȳ − α2 Z̄, α2 6= 0. (6)
The reason α2 has to be non-zero is to prevent equilibrium prices from
being fully revealing. The closed form solution has been found in [5], Huang
and Litzenberger. From the price function above, it is clear that price is
affected by both Ȳ and Z̃. It is not possible to isolate the effect of either of
the two individually and correspondingly price does not reveal all the infor-
mation. A similar but generalized model has been developed by Diamond

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and Verracchia (1980). They consider the equilibrium price as a function of
investor information only through their individual demands.
A natural extension is to consider more assets and Admati (1985) uses
similar framework to extend the model to multiple assets and a continuum
of investors. In the paper she is able to find closed-form expressions for
prices and, more interestingly, develop number of examples to show the
existance of counter-intuitive results in the multi-asset environment. These
results cannot be obtained from a generalization of the two asset models.
An example demonstrating how such results can be obtained is delineated
later but the driving force behind such results is the correlation among the
payoffs and among the supply of different assets i.e. the structure of the
variance-covariance matrices.
For the model with N risky and one riskless asset with T traders, the
expression for time 1 wealth is given by

W1i = θi0 (F̃ − P ) + W0i ,

and the price function is taken as

T
X
P = α0 + α1i Yi − α2 Z̃.
i=1

The notation now represent matrices rather than scalars. Lastly, the signals
of individuals are allowed to be asymmetric by having different variances.
Admati develops her model in the case of infinite investors. These con-
tinuum of investors are indexed by a ∈ [0, 1] and the economy is defined
as a function (ρ, S −1 ) : [0, 1] → <+ X <nXn , where (ρa , Sa−1 ) is the value
of the function at a. Each agent observes the signal Y˜a = F̃ + ˜a where
(a )a∈[0,1] are i.i.d normal with mean vector zero and covariance Sa . The
price function used by Admati in the continuum of agent case is

P = α0 + α1 X̃ − α2 Z̃. (7)

Here price is a function of the actual future payoff of the asset and not
the aggregate information becuase the collective information of all infinite
agents in the economy averages out the error terms and the market as a
whole has perfect information about the cash flows. 1 The paper describes
1
If (ξ˜a )a∈[0,1] is a stochastic process, then the Lebegue integral 0 ξ˜a da might or might
1
R
not be well defined because of measurability constraint on the realization of our process
(as a function of a). But if E(ξ˜a ) = 0, ∀a and Var(ξ˜a ) are uniformly bounded, then for
every sequence {an } of distinct indices from [0,1], the strong law of large numbers applied
PN
to the sequence (ξa˜n ) yields that (1/N ) n=1 ξa˜n → 0 almost surely. Admati thus claims
R1
it is reasonable to define 0
ξ˜a da = 0. She first assumes the integral she is defining is linear
1 1 1
and writes it as 0 ξ˜a da = 0 (ξ˜a − E(ξ˜a ))da + 0 E(ξ˜a )da. The first term on the right
R R R
goes to zero by the argument above and hence the result follows. She continues with the

5
how a closed form solution for the model is obtained and what are the factors
affecting the constants in the price function. The counter-intuitive results
obtained for a multi-asset can be best seen using a simple example taken
from the paper.
Consider two risky assets a and b with the covariance matrix for F̃ and
Z̃ respectively being !
vaa vab
V =
vba vbb
!
uaa uab
U=
uba ubb
Let vbb >> vaa > 0 and uaa > ubb > 0 for our example. Consider an increase
in the price of asset a, Pa with the price of asset b, Pb held constant. A
rational investor will take this as a signal of higher future payoff for asset a,
F̃a . The high degree of positive correlation between the payoffs of the two
assets would then suggest that the payoff of asset b, F̃b , would also increase,
and by a greater amount. The only way Pb is expected to remain constant
is if it’s supply, Z̃b , increases. The positive correlation between the supply
of the assets would again mean that supply of a, Z̃a , also increases, and
by more than Z̃b . This will tend to decrease Pa beyond the initial increase.
So an increase in F̃a resulting from an increase in Pa with Pb held constant
produces inconsistent result. A decrease in F̃a is more consistent: When F̃a
decreases, F̃b also reduces and to keep prices constant, there is an drop in Z̃b .
This is accompanied by decrease in Z̃a , which raises Pa and reinforces the
initial increase. Hence we see that increase in the price of the asset might
lead to decrease in future payoff. This is one example which goes against the
intuition developed in earlier models and shows how the variance-covariance
stucture can produce suprising results when multiple assets are considered.
Another impressive feature of a multi-asset economy which comes out of
the Admati paper is that the supply of each asset in the economy does not
have to be unknown for the equilibrium to be stable. Noise in the supply
in any asset affects the prices of remaining assets (the exact degree depends
on the correlation structure) and prevents the prices of assets with known
supplies from becoming fully revealing. Secondly, even if the payoff of an
asset is known perfectly, the investor can obtain information about other
assets through signal relating to this first asset. This is again due to the
correlation between different assets in the economy. So the conditions for
the equilibrium to exist in this setting are not as strict as those in the earlier
models.
argument that if (ξ˜a )a∈[0,1] are as above and (ξ˜a0 )a∈[0,1] is almost surely integrable, then
R1 R1
0
(ξ˜a + ξ˜a0 )da = 0 ξ˜a0 da. Now if we return to our model, the error terms {˜a }a∈[0,1] is
R1 R1
similar as the (ξ˜a0 )a∈[0,1] above and so we can write 0 Y˜a da = 0 (X̃ + ˜a )da = X̃ almost
surely.

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 An alternative direction of reseach relates to models where investors
have to pay to acquire information. In such models, they have to make the
decision to buy the information or not, depending on how that effects their
expected utility. Grossman and Stiglitz (1980) explore this in a Two-Asset
Two-Period setting.
The model is constructed as follows. There is one piece of information
and all investors who decide to buy get the same information. The payoff
F̃ of the risky asset is random and given by F̃ = θ + . Investors can know
the value of θ at a price k. The informed and the uninformed investors
are identical apriori and the classification just depends on whether they
purchase information or not. When traders buy information, they obtain
knowledge of the payoff accurately to a precision of , and their demand for
the risky asset then depends on θ and P , the price in the market. Demand
of uninformed individuals just depends on P . The supply of the asset is
random denoted by Z̃. If λ denotes the percentage of investors who decide
to become informed, then the price function is of the form Pλ (z, θ). The
uninformed don’t know the value of z and hence cannot extrapolate θ from
price.
The amount of information the investors can extract from the equilib-
rium price depends on how noisy the price is. The investors weigh this
against the benefit if they buy the information. At the margin, the ex-
pected benefit from buying information is zero. Thus the equilibrium can
be obtained by equating the expected utility of the informed and the unin-
formed. As long as these two are different, investors will find it profitable
to switch sides. Grossman and Stiglitz come up with a number of general
conjectures which should be true for a general model of this form. Some of
them are discussed below.

• As the number of informed investors increase, the price system be-

comes more informative. This reduces the utility of being informed
and the ratio of utility of informed to the uninformed decreases. This
drives the ratio of utilities to one and the market towards equilibrium.

• A rise in the price of information reduces the expected benefit of the

information and consequently the fraction of investors who decide to
become informed in equilibrium is a decreasing function of the price
of information.

• Increase in the quality of information without any increase in its price

produces ambigious results. On one side, this will encourage investors
to buy information, since it is more informative. But better quality
information will mean that investors who buy information are making
more informed decisions, and so the price system is more revealing.
This increases the expected benefit for the uninformed, discouraging
them from buying information.

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 • The noise in the system in the form stochastic supply of assets is the
reason prices are not fully revealing. It is clear that more the noise in
the system, less informative is the price.

Grossman and Stiglitz are not able to verify the conjectures for a general
model, but they are able to prove their arguments for a special case where in-
vestors have constant risk aversion and all variables are normally distributed.
Their closed form solution shows how the ratio of utilities change with the
fraction of informed investors. They analyze the case where prices reveal all
information as limiting cases of their model by letting the variance of noise
go to zero. The results show that as the variance of noise goes to zero, the
proportion of informed traders also go to zero. Hence we have fully revealing
prices and the equilibrium breaks down.
In the final section of their paper, Grossman and Stiglitz argue why
prices cannot be fully revealing. They start by pointing out that differences
in preference is not the only reason driving trade, and differences in endow-
ment and belief are also important reasons why people trade. Disregarding
differences in preferences, if all traders have identical endowments and be-
liefs then a competitive equilibrium would leave them with exactly the same
share as their endowments, and nobody would trade if there is some cost
involved. Grossman and Stiglitz then go on to show there there is continuity
in net trade with respect to differences in beliefs. Based on this argument,
as the noise in prices go to zero, traders become identically informed having
identical beliefs, and trading thins down to zero. If operating the market is
costly it will close down before the equilibrium ceases to exist.

3 Future Reading and Research

Some areas for further reading and consideration for research are highlighted
below.

1. Noise, in the form of stochastic supply of assets, prevent prices from

being fully revealing and makes the above models stable. Diamond
and Verracchia (1980) write that “introducing noise in such a manner
may appear somewhat artificial”. They propose other plausible sources
of noise such as “individually stochastic life cycle motives for trade”,
“individually stochastic taxes” and wonder whether these alternative
sources might give more insight into the nature and role of noise in
the rational expectations equilibrium.
I argue that treating supply of assets as random in the models is not
unreasonable and should be interprated as a mixture of stochastic life
cycle of individual’s trade, which Diamond and Verracchia suggest,
and ’Limited Participation’ in trading. For the former I reason that
most investors have some fixed random time they would like stick

8
 with their investment before they engage in buying or selling the asset
in question again. During this time, their supply is absent from the
market when the price is being determined. The Limited Participation
I mention is meant to capture the idea that “Not all investors are
watching prices of all the assets all the time”. This might be specially
true for assets which are not traded often or assets which make a very
small percentage of portfolios. This makes it impossible to give an
accurate figure for the total supply of the asset.

2. All the above models are for a competitive equilibrium where individ-
ual investors are price takers. Kyle’s (1989) work addresses the case
where the market is imperfect and individual traders can manipulate
prices. A Bayesian-Nash Equilibrium framework is used to explore
the implications and develop the model. The justification for explor-
ing such a market is that the best informed traders are usually the
very large traders who have the capacity of ‘moving the market’.

3. Except for the last model, investors are costlessly endowed with infor-
mation. Treating information gathering as costly would enhance our
understanding of the market equilibrium. A more complicated model
can be constructed by assuming investors have a choice to buy private
heterogeneous information corresponding to payoffs of risky assets.
There could be multiple sources of information with non-uniform cost.
The resulting model could be much closer to reality but tractability
of such a model is a serious concern. The other aspect to consider is
how much would it really add to our understanding of the equilibrium
process.
We can start by looking at Grossman and Stiglitz (1980) and analyze
what happens if we increase from one to two, at non-uniform cost,
the pieces of information investors can buy. Do we just get a more
complicated model, with no enhancement of our understanding, or do
we see some interesting results? What if these pieces of information
are not independent? There is scope in this direction and reasonable
assumptions might provide mathematical tractability.

4. A prominent work for future reference is by Campbell and Kyle(1993).

5. An idea suggested by Prof David Brown was to use the Multi-Asset

Admati model but have teh cash flows take on a factor structure. Un-
fortunately, the analysis became intractable because the simple struc-
ture exploited by Admati for her paper vanished. A different approach
will have to be used if a solution is to be obtained. Hughes, Liu and
Liu (2005) have tried to accomplish a similar goal in their paper and
it should be interesting going through their analysis.

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4 References
1. Grossman, S.J., 1976, On the Efficiency of Competitive Stock Mar-
kets Where Trades Have Diverse Information. Journal of Finance, Vol
31, No 2, 573-585.

2. Diamond, D.W. and Verracchia R.E., 1980, Information Aggre-

gation in a Noisy Rational Expectations Economy, Journal of Financial
Economics 9, 221-235.

3. Admati, A.R., 1985, A Noisy Rational Expectations Equilibrium

for Multi-Asset Securities Markets, Econometrica, Vol. 53, No. 3,
629-658.

4. Grossman, S.J. and Stiglitz, J.E., 1980, On the impossibility of In-

formationally Efficient Markets, American Economic Review 70, 393-
408.

5. Lintner, J., 1969, The Aggregation of Investors Diverse Judgments

and Preferences in Purely Competitive Security Markets, Journal of
Financial and Quantitative Analysis 4, 347-400.

6. Huang,C. and Litzenberger,R.H., Foundations for Financial Eco-

nomics, 259-283.

7. Campbell, J.Y. and Kyle, A.S., 1993, Smart Money, Noise Trading
and Stock Price Behavior, Review of Economic Studies, 60, 1-34.

8. Kyle, A.S., 1989, Informed Speculation with Imperfect Competition,

The Review of Economic Studies, Vol. 56, No.3, 317-355.

9. Hellwig, M.F., 1980, On the aggregation of information in competi-

tive markets, Journal of Economic Theory, Vol 22, 477-498.

10. Hughes, J., Liu, J. and Liu, J.,2005, Information, Diversification

and Asset Pricing, Unpublished.

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