Consider a securities market where price-sensitive information is available only to participants who pay a fixed cost in money or effort. So only paid-up agents know the fair prices of securities. However, not all agents would be willing to pay for information. Some would argue that because there are enough informed market participants, ensuring that securities are correctly priced, why then incur the “unnecessary” cost of gathering information? (Passive or index-tracking investors would fall into this category.)
But if all market participants follow this argument, no one will be able to determine the fair price of a security and the market cannot be efficient. In fact, the market cannot function, as participants who enter or exit the market will trade at random prices. This is called the Grossman-Stiglitz paradox (Grossman and Stiglitz (1980)). So for the market to function, the agents who pay for information must receive compensation in the form of trading profits.
If all agents pay to be informed, only the liquidity providers, as discussed previously, will outperform. But then, how would the market function if only some agents are informed?
Typically, we would expect the uninformed only to trade due to a change in their circumstances, as discussed previously. Informed agents would participate, not only due to a change in their circumstances, but also for the sake of making a profit. In the latter case, they function as arbitrageurs.
In practice, trading occurs at ruling prices until there are no more buyers or no more sellers at that price. Assuming that the ruling price is below fair value, arbitrageurs will keep on buying a security until there are no more uninformed or forced sellers. A queue of buyers, consisting of arbitrageurs and uninformed agents, remain. Given that there are no further sellers, the uninformed buyers in the queue would conclude that the fair price of the security is equal to or higher than the current ruling price, else there would have been arbitrageurs willing to sell to them. Uninformed buyers will bid at higher prices and the security’s price will rise to a level above fair value where arbitrageurs are prepared to sell.
The same argument holds for securities trading above fair value. The market ends up with a queue of informed and uninformed sellers. The price will then drop to a level below fair value where arbitrageurs are prepared to buy from the uninformed sellers.
In the absence of new price-sensitive information, the price of a security will settle in a range around fair value where arbitrageurs primarily make money by providing “liquidity” to uninformed participants entering or exiting the market. The cost of timeously gathering price sensitive information would determine the size of the price range around fair value.
When new price-sensitive information arrives arbitrageurs will make money at the cost of uninformed participants until the security’s price reaches the new fair value. The larger the magnitude by which a security’s fair value changes due to news, the larger the gain to informed agents at the cost of uninformed agents.
Also, the higher the ratio of informed relative to uninformed agents the smaller the benefits that accrue to informed agents. This is because there are fewer agents who willingly trade at prices away from the fair value.