Incentives for information production in markets where prices affect real investment

Dow, J, Goldstein, I and Guembel, A (2013) Incentives for information production in markets where prices affect real investment. Working Paper. London Business School IFA Working Paper.

Abstract

We analyze the incentives for ficial market traders to produce information about a firm’s investment opportunities, where such information may be noisily revealed in stock prices and thereby improve a firm’s resource allocation decisions. We show that incentives to produce costly information are sensitive to the ex ante likelihood with which an investment is undertaken by a firm. The more likely a firm is not to invest, the more likely it becomes that the traders’ information will have no speculative value. This generates an informational amplification effect of shocks to firm value. We show that information production by traders may exhibit strategic complementarities when projects would not be undertaken in the absence of positive news from the stock market. In these circumstances a small decline in a firm’s fundamentals can lead to a market breakdown where information production stops and there is a collapse in investment and firm value.