On Divergence of Opinion and Imperfections in Capital Markets

Abstract

importance of divergence of opinion the functioning of capital markets was recognized by early economic writers. In the prevailing models of capital markets, however, differences of opinion either do not exist or do not matter. Thus, although heterogeneity of opinion is allowed the models developed by Kenneth Arrow, Gerard Debreu, and Peter Diamond, nothing essential would change if all individuals were to hold identical, homogeneous-equivalent average expectations. In the capital asset pricing model (CAPM) of William Sharpe (1964) and John Lintner (1965), homogeneous expectations are assumed at the outset. When they considered the implications of heterogeneity of expectations the model, both Lintner (1969) and Sharpe (1970) reached similar conclusions; as stated by Sharpe, in somewhat superficial sense the equilibrium relationships derived for world of complete agreement can be said to apply to world which there is disagreement, if certain values are considered to be averages (p. 291). Sharpe's conclusion was that a model based on disagreement has little value positive role (p. 113). aim of this paper is to present simple model of exchange capital markets where divergence of opinion not only exists, but is essential. It is essential because of its association with endogenous limitations on the number of active market participants. It will be argued that the models cited above, the significance of divergence of opinion was dismissed because of the failure to recognize the implications of the obvious fact that investors choose not only the size of their holdings each asset, but also which assets to invest. Correspondingly, they failed to recognize that (imperfect) capital markets, equilibrium requires the simultaneous determination of asset prices and the identity of investors trading each asset. As both Lintner (1969) and Sharpe (1970) recognized, the case of divergent opinions may differ from the case which there is no such divergence, if only because it implies that investors may seek to sell short assets that they believe to be overrated. Lintner, who pursued the implications of the case which short sales are not allowed, argued that, when not all investors trade every asset, the price of an asset will reflect an average of the assessments of only those investors who actually hold the asset. Lintner, however, did not realize that, given that the set of active investors is endogenously determined, this is an incomplete characterization of how asset prices are determined. It leaves an integral question unanswered; namely, what distinguishes the active from the nonactive investor? Lintner was thus led to dismiss an alternative characterization of equilibrium asset prices-the marginal-investor theory-proposed by John Maynard Keynes and John Burr Williams thirty years earlier.' Keynes characterized the determination of asset prices manner that attests to the importance that he attached to divergence of opinion among investors: The prices of capital assets move until... they offer an

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