September 13, 2010, 17:00–18:30
Room MF 323
Political Economy Seminar
This paper studies an environment in which information aggregation interacts with investment decisions. The first contribution of the paper is to develop a tractable model of such interactions. The second contribution is to solve the model in closed form and derive a series of implications that result from the interplay between information aggregation and the value of market information for the firms' decision problem. We show that the model generates an information aggregation wedge between price and expected dividend value. The information aggregation wedge is asymmetric: larger on the upside, when there is a lot of investment, and shares are over-valued, than on the downside, when there is little investment, and shares are under-valued. On average the share price exceeds the expected dividend value. We therefore arrive at a theory of share price over-valuation due to information feedback. Third, we discuss the role of managerial incentives which are tied to the firm's share price. We show that our model provides a theory linking price-based incentives to asset over-valuation and excess volatility of investment. When the managers seek to maximize share prices instead of expected dividends, their decisions will attribute too much weight to market information, relative to the optimum.