Heterogeneous preferences, price informativeness, and welfare

Abstract

We study the informational and allocative efficiency of market prices in the presence of preference heterogeneity/inequality, and how transaction costs affect efficiency. We consider a rational expectations equilibrium (REE) model of an exchange with heterogeneous marginal utilities and private information. We establish an equilibrium with partially-revealing prices that aggregate private information inefficiently. We also show that the informational inefficiency also leads to allocational inefficiency, because rich (poor) agents do not internalize that their information is more (less) incorporated in market prices than the average signal. Finally, we study how the introduction of quadratic transaction costs can mitigate or alleviate the informational and allocational efficiency.