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AmericanEconomicAssociationOntheImpossibilityofInformationallyEfficientMarketsAuthor(s):SanfordJ.GrossmanandJosephE.StiglitzSource:TheAmericanEconomicReview,Vol.70,No.3(Jun.,1980),pp.393-408Publishedby:AmericanEconomicAssociationStableURL::12/01/201008:35YouruseoftheJSTORarchiveindicatesyouracceptanceofJSTOR'sTermsandConditionsofUse,availableat://=aea.EachcopyofanypartofaJSTORtransmissionmustcontainthesamecopyrightnoticethatappearsonthescreenorprintedpageofsuchtransmission.JSTORisanot-for-profitservicethathelpsscholars,researchers,andstudentsdiscover,use,andbuilduponawiderangeofcontentinatrusteddigitalarchive.Weuseinformationtechnologyandtoolstoincreaseproductivityandfacilitatenewformsofscholarship.FormoreinformationaboutJSTOR,pleasecontactsupport@jstor.org.AmericanEconomicAssociationiscollaboratingwithJSTORtodigitize,preserveandextendaccesstoTheAmericanEconomicReview.*Ifcompetitiveequilibriumisdefinedasasituationinwhichpricesaresuchthatallarbitrageprofitsareeliminated,isitpossiblethatacompetitiveeconomyalwaysbeinequilibrium?Clearlynot,forthenthosewhoarbitragemakeno(private)returnfromtheir(privately)costlyactivity.Hencetheassumptionsthatallmarkets,includingthatforinformation,arealwaysinequilibriumandalwaysperfectlyarbitragedareincon-sistentwhenarbitrageiscostly.Weproposehereamodelinwhichthereisanequilibriumdegreeofdisequilibrium:pricesreflecttheinformationofinformedindividuals(arbitrageurs)butonlypartially,sothatthosewhoexpendresourcestoob-taininformationdoreceivecompensation.Howinformativethepricesystemisde-pendsonthenumberofindividualswhoareinformed;butthenumberofindividualswhoareinformedisitselfanendogenousvariableinthemodel.Themodelisthesimplestoneinwhichpricesperformawell-articulatedroleincon-veyinginformationfromtheinformedtotheuninformed.Wheninformedindividualsob-serveinformationthatthereturntoasecur-ityisgoingtobehigh,theybiditspriceup,andconverselywhentheyobserveinforma-tionthatthereturnisgoingtobelow.Thusthepricesystemmakespubliclyavailabletheinformationobtainedbyinformedindi-vidualstotheuniformed.Ingeneral,how-ever,itdoesthisimperfectly;thisisperhapslucky,forwereittodoitperfectly,anequilibriumwouldnotexist.Intheintroduction,weshalldiscussthegeneralmethodologyandpresentsomecon-jecturesconcerningcertainpropertiesoftheequilibrium.Theremaininganalyticsectionsofthepaperaredevotedtoanalyzingindetailanimportantexampleofourgeneralmodel,inwhichourconjecturesconcerningthenatureoftheequilibriumcanbeshowntobecorrect.Weconcludewithadiscussionoftheimplicationsofourapproachandresults,withparticularemphasisontherela-tionshipofourresultstotheliteratureonefficientcapitalmarkets.I.TheModelOurmodelcanbeviewedasanextensionofthenoisyrationalexpectationsmodelin-troducedbyRobertLucasandappliedtothestudyofinformationflowsbetweentradersbyJerryGreen(1973);Grossman(1975,1976,1978);andRichardKihlstromandLeonardMirman.Therearetwoassets:asafeassetyieldingareturnR,andariskyasset,thereturntowhich,u,variesran-domlyfromperiodtoperiod.Thevariableuconsistsoftwoparts,(1)=+ewhere9isobservableatacostc,andeisunobservable.'Both9andEarerandomvariables.Therearetwotypesofindividu-als,thosewhoobserve9(informedtraders),andthosewhoobserveonlyprice(unin-formedtraders).Inoursimplemodel,allindividualsare,exante,identical;whethertheyareinformedoruninformedjustde-pendsonwhethertheyhavespentctoob-taininformation.Informedtraders'de-mandswilldependon9andthepriceoftheriskyassetP.Uninformedtraders'demands*UniversityofPennsylvaniaandPrincetonUniver-sity,respectively.ResearchsupportunderNationalSci-enceFoundationgrantsSOC76-18771andSOC77-15980isgratefullyacknowledged.ThisisarevisedversionofapaperpresentedattheEconometricSocietymeetings,Winter1975,atDallas,Texas.'Analternativeinterpretationisthat0isamea-surementofuwitherror.Themathematicsofthisalternativeinterpretationdifferslightly,buttheresultsareidentical.393394THEAMERICANECONOMICREVIEWJUNE1980willdependonlyonP,butweshallassumethattheyhaverationalexpectations;theylearntherelationshipbetweenthedistribu-tionofreturnandtheprice,andusethisinderivingtheirdemandfortheriskyassets.Ifxdenotesthesupplyoftheriskyasset,anequilibriumwhenagivenpercentage,X,oftradersareinformed,isthusapricefunctionPA(O,x)suchthat,whendemandsarefor-mulatedinthewaydescribed,demandequalssupply.Weassumethatuninformedtradersdonotobservex.Uninformedtradersarepreventedfromlearning9viaobservationsofPA(O,x)becausetheycan-notdistinguishvariationsinpriceduetochangesint