Insider Trading In A Rational Expectations Economy

Abstract

It is often argued that efficiency considerations require society to freely permit insider trading. In this article, an opposing efficiency argument is formalized. The model incorporates an investment stage followed by a trading stage. If "outsiders" expect "insiders" to take advantage of them in trading, outsiders will reduce their investment. The insiders' loss from this diminished investor confidence may more than offset their trading gains. Consequently, a prohibition on insider trading may effect a Pareto improvement. Insiders are made better off if they can precommit not to trade on their privileged information; government regulation accomplished exactly this. Copyright 1990 by American Economic Association.