Skip to main content

Knowledge flows and insider trading

Abstract

Much insider trading literature focuses on the redistribution of monetary rents. This focus has led to ambiguous and conflicting results, unable to identify who the clear winners and losers of insider trading legislation are. Lacking any clearly defined beneficiary, an analysis of the origins and continued support of such legislation is lacking. This paper rectifies this omission by reassessing the involved agents not in light of their relationship to a company, but from all roles of the knowledge transmission process: creator, distributor and user. Information distributors—large news companies and investment houses—are argued to be sufficiently well organized to lobby for maintained and strengthened legislation to protect rents that would otherwise be greatly diminished.

This is a preview of subscription content, access via your institution.

Fig. 1

Notes

  1. Varied empirical results reflect these theoretical conflicts. Evidence from Bettis et al. (1998) and Durnev and Nain (2005) confirm that insiders continue to earn gains through the use of non-public information. In contrast, Carlton and Fischel (1983) find alternative evidence that management fails to profit through insider trading, instead settling for reduced salaries.

  2. The extent to which these laws are enforced is not uniform. Roe (2000) finds that left-leaning governments favor the redistribution of property rights (including insider information) away from capital owners and into the hands of employees. Alternatively, corrupt regimes tend to be more insider-based than less corrupt regimes (Polinsky and Shavell 2001; Beny 2002: 21).

  3. Haddock and Macey (1987: 324) note that the inclusion of individual investors could be rendered with a third axis to include individual investors and could be “imagined as a pancake—broad and wide but rather thin.” The weak organization and influence of the individual investors gives them little influence compared to the other two groups.

  4. Or, as Milton Friedman comments on the matter: “You want more insider trading, not less. You want to give the people most likely to have knowledge about deficiencies of the company an incentive to make the public aware of that” (as quoted in Harris 2003).

  5. Increases in knowledge can lead to corresponding increases in “confusion, ignorance, and conceit” (Taleb 2007: 138). This can be analogized to the pouring of red wine into a glass of water. At first the water will turn rose very quickly, but reach a saturation point whereby no effect will be elicited from additional wine. After they are mixed, we will be unable to tell which wine it is that colored the water, and which was added after the saturation point. Likewise, as new information is added to our existing knowledge we are unable to discern which increased the scope of our understanding, and which leads to new confusion surrounding the implications of the greater amount of knowledge we must act upon.

  6. Howden (2010) invokes this argument to demonstrate why the banking system faces increasing data deterioration during an inflationary process. As knowledge of the source of additional credit in the banking system—whether savings or credit induced—is lost the further one is from the original source of the new credit (i.e., the central bank) less understanding is available as to the consequences and profit opportunities of this new credit.

  7. This result is similar to that of the dictator game in Eichenberger and Oberholzer-Gee (1997).

  8. The uncertainty of future success incentivizes one group to favor this insurance policy (Buchanan and Tullock 1962). Agents who expect their future income to be lower than the average favor this redistribution that shifts everyone’s’ income level to the middle, leaving no outliers (either rich or poor).

References

  • Alchian, A. A., & Demsetz, H. (1972). Production, information costs, and economic organization. American Economic Review, 62(5), 777–795.

    Google Scholar 

  • Bebchuk, L., & Jolls, C. (1999). Managerial value diversion and shareholder wealth. Journal of Law, Economics, and Organization, 15(2), 487–502.

    Article  Google Scholar 

  • Becker, G. S. (1983). A theory of competition among pressure groups for political influence. Quarterly Journal of Economics, 98(3), 371–400.

    Article  Google Scholar 

  • Becker, G. S. (1986). The public interest hypothesis revisited: A new test of Peltzman’s theory of regulation. Public Choice, 49(3), 223–234.

    Article  Google Scholar 

  • Beny, L.N. (2002). The political economy of insider trading legislation and enforcement: International evidence. Harvard Law School John M. Olin Center for Law, Economics and Business, Discussion Paper Series. Paper 348.

  • Bettis, J. C., Ducan, W. A., & Harmon, W. K. (1998). The effectiveness of insider trading regulations. Journal of Applied Business Research, 14(4), 53–70.

    Google Scholar 

  • Bris, A. (2005). Do insider trading laws work? European Financial Management, 11(3), 267–312.

    Article  Google Scholar 

  • Buchanan, J. M., & Tullock, G. (1962). The calculus of consent. Ann Arbor: University of Michigan Press.

    Google Scholar 

  • Carlton, D. W., & Fischel, D. R. (1983). The regulation of insider trading. Stanford Law Review, 35(5), 857–895.

    Article  Google Scholar 

  • Durnev, A.A., & Nain, A.S. (2005). The effectiveness of insider trading regulation around the globe. William Davidson Institute. Working paper #695.

  • Easterbrook, F. H. (1985). Insider trading as an agency problem. In J. W. Pratt & R. Zeckhauser (Eds.), Principles and agents: The structure of business. Boston: Harvard Business School Press.

    Google Scholar 

  • Eichenberger, R., & Oberholzer-Gee, F. (1997). Rational moralists: The role of fairness in democratic economic politics. Public Choice, 94(1), 191–210.

    Google Scholar 

  • Georgakopoulos, N. (1993). Insider trading as a transactional cost: A market microstructure justification and optimization of insider trading regulation. Connecticut Law Review, 26, 1–51.

    Google Scholar 

  • Goshen, Z., & Parchomovsky, G. (2000). On insider trading markets, andnegativeproperty rights in information. Fordham Law and Economics Research Paper No. 06.

  • Haddock, D. D., & Macey, J. R. (1987). Regulation on demand: A private interest model, with an application to insider trading regulation. Journal of Law and Economics, 30(2), 311–352.

    Article  Google Scholar 

  • Harris, L. (2003). Trading & exchanges: Market microstructure for practitioners. Oxford: Oxford University Press.

    Google Scholar 

  • Hayek, F. A. (1976). Law, legislation and liberty, volume 2: The mirage of social justice. Chicago: The University of Chicago Press.

    Google Scholar 

  • Howden, D. (2010). Knowledge shifts and the business cycle: When boom turns to bust. Review of Austrian Economics, 23(2), 165–182.

    Article  Google Scholar 

  • Huerta de Soto, J. (2010). Socialism, economic calculation and entrepreneurship (trans.) Melinda Stroup. Cheltenham, UK: Edward Elgar.

  • Jeng, L., Metrick, A., & Zeckhauser, R. (1999). The profits to insider trading: A performance-evaluation perspective. NBER Working Paper No. W6913.

  • Keeler, T. E. (1984). Theories of regulation and the deregulation movement. Public Choice, 44(1), 103–145.

    Article  Google Scholar 

  • Lavoie, D. (1985). National economic planning: What is left? Washington, DC: CATO Institute.

    Google Scholar 

  • Macey, J. R. (1991). Insider trading: Economics, politics, and policy. Washington, DC: The AEI Press.

    Google Scholar 

  • Machan, T. R. (1996). What is morally right with insider trading. Public Affairs Quarterly, 10(2), 135–142.

    Google Scholar 

  • Manne, H. G. (1965). Mergers and the market for corporate control. Journal of Political Economy, 73(2), 110–120.

    Article  Google Scholar 

  • Manne, H. G. (1966a). Insider trading and the stock market. New York: The Free Press.

    Google Scholar 

  • Manne, H. G. (1966b). In defense of insider trading. Harvard Business Review, 44(6), 113–122.

    Google Scholar 

  • Mayer, T. (2005). Information, knowledge, understanding and wisdom. Economic Journal Watch, 2(1), 66–69.

    Google Scholar 

  • Olson, M. (1969). The logic of collective action. Cambridge, MA: Harvard University Press.

    Google Scholar 

  • Padilla, A. (2002). Can agency theory justify the regulation of insider trading? The Quarterly Journal of Austrian Economics, 5(1), 3–38.

    Article  Google Scholar 

  • Padilla, A. (2005). The regulation of insider trading as an agency problem. bepress Legal Series. Working paper 641.

  • Peltzman, S. (1976). Toward a more general theory of regulation. Journal of Law and Economics, 19(2), 211–240.

    Article  Google Scholar 

  • Polinsky, M. A., & Shavell, S. (2001). Corruption and optimal law enforcement. Journal of Public Economics, 81(1), 1–24.

    Google Scholar 

  • Prechter, R. R., Jr. (2001). Unconscious herding behavior as the psychological basis of financial market trends and patterns. The Journal of Psychology and Financial Markets, 2(3), 120–125.

    Article  Google Scholar 

  • Primaux, W. J., Filer, J. E., Herren, R. S., & Hollas, D. R. (1984). Determinants of regulatory policies toward competition in the electric utility industry. Public Choice, 43(2), 173–186.

    Article  Google Scholar 

  • Roe, M. (2000). Political preconditions to separating ownership from corporate control. Stanford Law Review, 53(3), 139–606.

    Google Scholar 

  • Shin, J. (1996). The optimal regulation of insider trading. Journal of Financial Intermediation, 5(1), 49–73.

    Article  Google Scholar 

  • Shleifer, A., & Vishny, R. W. (1986). Large shareholders and corporate control. Journal of Political Economy, 94(3), 461–488.

    Article  Google Scholar 

  • Taleb, N. N. (2007). The black swan: The impact of the highly improbable. New York: Random House.

    Google Scholar 

Download references

Author information

Authors and Affiliations

Authors

Corresponding author

Correspondence to David Howden.

Additional information

I would like to thank Philipp Bagus, Pete Boettke, Tony Carilli, Adam Martin, Frederic Sautet, Tyler Watts, and two anonymous referees for helpful comments. All remaining errors are my own.

Rights and permissions

Reprints and Permissions

About this article

Cite this article

Howden, D. Knowledge flows and insider trading. Rev Austrian Econ 27, 45–55 (2014). https://doi.org/10.1007/s11138-013-0209-9

Download citation

  • Published:

  • Issue Date:

  • DOI: https://doi.org/10.1007/s11138-013-0209-9

Keywords

  • Insider information
  • Asymmetric information
  • Redistribution
  • Regulation

JEL classification

  • D72
  • D82
  • G14
  • K22