Despite Absolute Information Advantages, All Investors Incur Welfare Loss

TL;DR

This paper investigates how investor heterogeneity in signal reliability affects market welfare, revealing that even with absolute information advantages, investors often incur welfare losses due to biased beliefs and information distortion.

Contribution

It introduces a novel model with biased investor beliefs, analyzes welfare impacts using objective measures, and explores the effects of investor proportion and belief manipulation on market outcomes.

Findings

Welfare losses occur despite absolute information advantages.

Bias in beliefs can lead to double welfare loss.

Manipulating investor beliefs can improve utility.

Abstract

This paper delves into financial markets that incorporate a novel form of heterogeneity among investors, specifically in terms of their beliefs regarding the reliability of signals in the business cycle economy model, which may be biased. Unlike most papers in this field, we not only analyze the equilibrium but also examine welfare using objective measures while investors aim to maximize their utility based on subjective measures. Furthermore, we introduce passive investors and use their utility as a benchmark, thereby revealing the phenomenon of double loss sometimes. In the analysis, we examine two effects: the distortion effect on total welfare and the advantage effect of information and highlight their key factors of influence, with a particular emphasis on the proportion of investors. We also demonstrate that manipulating investors' estimation towards the economy can be a way to improve utility and identify an inner connection between welfare and survival.