Reference

Adam Zawadowski (Central European University), Learning in Crowded Markets, Fédération des Banques Françaises Seminar, Toulouse: IDEI, April 24, 2017, 12:30–14:00, room MF 323.

Abstract

We study how competition among investors affects the efficiency of capital allocation and welfare. We develop a novel game of entry with rational inattention in which investors learn about their relative advantage compared to others in a fully flexible way. Competition leads to better, e.g. more talented or faster, investors entering the market. However, this does not necessarily improve the efficiency of capital allocation: there is persistent over- or underinvestment. As the entrance of better investors is a by-product of costly over-learning, increasing competition decreases welfare. We describe how the composition of entrants and the level of over- or underinvestment depend on market and investor characteristics. We also highlight that restricting signals to be Gaussian in the learning process is not without the loss of generality. With investors of heterogeneous skills, increasing the share of more sophisticated investors might harm welfare.