The social value of overreaction to information

• Main Authors: Bizzarri, Matteo, d'Arienzo, Daniele
• Format: Journal Article
• Language: English
• Published: 13-03-2024
• DOI: 10.48550/arxiv.2403.08532

We study the welfare effects of overreaction to information in the form of
diagnostic expectations in markets with asymmetric information, and the effect
of a simple intervention in the form of a tax or a subsidy. A large enough
level of overreaction is always welfare-decreasing and can rationalize a tax on
financial transactions. A small degree of overreaction to private information
can both increase or decrease welfare. This is because there are two competing
externalities: an information externality, due to the informational role of
prices, and a pecuniary externality, due to the allocative role of prices. When
the information externality prevails on the pecuniary externality, the loading
on private information in agents' trades is too small compared to the welfare
optimum: in this case, a small degree of overreaction is welfare-improving.