Estimating Investor Demand Elasticity with Endogenous Firm Responses

Abstract

Standard estimates of investor demand elasticity are biased when firms time equity issuance in response to demand shocks, conflating demand-driven price pressure with fundamental improvements. Using mutual fund flow shocks and a dynamic structural model estimated via indirect inference, I show that approximately 29% of the initial price response reflects endogenous fundamental improvement. Correcting for this bias yields a demand elasticity of 1.7, compared to 1.2 from standard price-based IV. The correction, combined with diminishing marginal price effects from strategic firm-investor interactions, implies moderate capital misallocation: a 43% reduction in fund flow shock volatility raises aggregate TFP by only 0.02%.

Keywords: Demand Elasticity, Structural Estimation, Equity Issuance, Market Timing, Mutual Fund Flows, Capital Misallocation