DP12045 Imperfect Financial Markets and Investment Inefficiencies
We analyze the consequences of noisy information aggregation for investment.
Market imperfections create endogenous rents that cause overinvestment in upside
risks and underinvestment in downside risks. In partial equilibrium, these
inefficiencies are particularly severe if upside risks are coupled with easy scalability
of investment. In general equilibrium, the shareholders’ collective attempts
to boost value of individual firms leads to a novel externality operating through
price that amplifies investment distortions with downside risks but offsets distortions
with upside risks.