Innovations, Rational Exuberance and Investment

Abstract

We examine information aggregation and capital accumulation when there is structural uncertainty regarding capital productivity at the industry-level and information is revealed strategically through bilateral contracting. Firms enter sequentially and uninformed investors design sequentially rational renegotiation-proof contracts, based on observations of previous contract outcomes, to elicit information from managers with private signals. For an open set of parameters, investors endogenously get "stuck" at overoptimistic posterior productivity expectations and the useful information of managers of newly entering firms does not get incorporated in their decisions. Information is therefore not aggregated asymptotically and there is long run over-investment (when the true productivity is low) even though there is bilateral contracting for inducing information revelation.

Keywords: Information aggregation, Investment, Bilateral contracting, Noisy revelation

JEL Classification: G32, D23