Abstract: This paper studies how heterogeneous preferences shape the informational and allocative efficiency of centralized markets with asymmetric information. We start by showing that introducing agent-level heterogeneity (e.g., in terms of trading costs) to the standard rational expectations equilibrium models reduces price informativeness by creating a bias towards the private information of agents with smaller trading costs. We then establish that this reduction in price informativeness in turn manifests itself as an informational externality: agents do not internalize the impact of their trading decisions on the information revealed to others via prices, even in competitive markets. We conclude the paper by investigating the welfare implications of market segmentation in the presence of this heterogeneity-induced informational externality.
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