Fully Revealing Equilibria with Suboptimal Investment

Abstract

This paper examines investment and financing policy in "fully revealing" equilibria--equilibria in which information asymmetries are resolved. Since all securities are priced correctly in a fully revealing equilibrium, it seems plausible that such equilibria would be free of the well known Myers-Majluf (1984) problem of inefficient investment. I show to the contrary that, for a large class of problems, whenever there is an equilibrium with efficient investment, there are also infinitely many equilibria in which almost all firms invest inefficiently. These inefficient outcomes survive the standard signaling-game equilibrium refinements. There are also examples that have fully revealing equilibria with inefficient investment but none with efficient investment. These findings contradict the claim of Constantinides and Grundy (1989) that firms invest the socially optimal amount in any fully revealing equilibrium.

JEL Classification: C73, G31, G32