Grossman-Stiglitz paradox implies that...[Fill in the blank]

Question

BlackTom AI · Accepted Answer

1. Identify and explain the relevant knowledge points and concepts
Grossman–Stiglitz (1980) establishes a fundamental paradox: if prices fully and costlessly reflected all information (strong-form efficiency), no one would have an incentive to acquire costly private information. But if no one acquires information, prices cannot fully reflect it. Therefore markets cannot be perfectly informationally efficient when information acquisition is costly. In equilibrium some investors gather information and are compensated for the costs they incur.

2. Complete reasoning process step by step
- Assume prices perfectly reflect all available information.  
- If that were true, buying costly information would yield no profit (no abnormal returns), so rational agents would stop acquiring it.  
- If agents stop acquiring information, prices no longer fully reflect information.  
- This contradiction implies perfect efficiency is impossible when information is costly.  
- The only consistent equilibrium is one where a subset of investors (security analysts) acquire information, incur costs, and earn expected gross returns that compensate those costs; their activity makes prices more informative.

3. Calculations / intermediate steps
No numeric calculation is required. The logical intermediate steps are: (a) full information => zero incentive to gather costly info; (b) zero info gathering => prices not fully informative; (c) contradiction => partial information production persists and is rewarded.

4. Explain WHY the correct answer is correct
Option b captures the equilibrium resolution of the paradox: because information collection is costly, security analysts provide a valuable service by producing and processing information; their actions help ensure prices are more informative. They earn returns that compensate costs, making their existence consistent with a market that is "efficient enough" but not perfectly efficient.

5. Why the other options are incorrect
- a: Incorrect because if everyone hired analysts, competition would eliminate abnormal returns net of cost; the paradox shows not everyone can earn abnormal profits.  
- c: Incorrect because a clear implication exists (options a, b, d are specific).  
- d: Incorrect because it contradicts the paradox: the industry does have a role — analysts earn compensation for costly information, so the industry can and does exist.

6. Conclusion confirming the final answer
The correct choice is b: when information collection and analysis are costly, security analysts offer a valuable service in ensuring that the market is efficient, and prices reflect information. This matches the provided answer.

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