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Rev Fin 1994; 7:575-608
© 1994 the Society for Financial Studies

Article

Insider trading, outside search, and resource allocation: why firms and society may disagree on insider trading restrictions

N Khanna1, SL Slezak2,z and M Bradley2
1 Michigan State University, USA
2 University of Michigan, School of Business Administration, Ann Arbor, MI 41809-1234, USA
z Corresponding author

Abstract

We show that entrepreneurs may prefer to allow insider trading even when it is not socially optimal. We examine a model in which an insider/manager allocates resources on the basis of his private information and outside information conveyed through the secondary-market price of the firm's shares. If the manager is allowed to trade, he will compete with informed outsiders, reducing the equilibrium quality of outside information. While the benefits to production of outside information are the same for society and entrepreneurs, we show that the social and private costs are different. Thus, entrepreneurs and society may disagree on the conditions under which insider trading restrictions should be imposed.


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