Rating agencies are often criticized for being biased in favor of borrowers, for being too slow to downgrade following credit quality deterioration, and for being oligopolists. Based on a model that takes into account the feedback effects of credit ratings, I show that: (i) rating agencies should focus not only on the accuracy of their ratings but also on the effects of their ratings on the probability of survival of the borrower; (ii) even when rating agencies pursue an accurate rating policy, multi-notch downgrades or immediate default may occur in response to small shocks to fundamentals; (iii) increased competition between rating agencies can lead to rating downgrades, increasing default frequency and reducing welfare.

Previous research has argued that debt financing affects equity-holders' investment decisions, producing substantial inefficiency. This paper shows that the size of this inefficiency depends on the degree of investment reversibility. In a dynamic model of financing and investment, the paper provides an upper bound for the inefficiency produced by debt financing. The upper bound is decreasing in the degree of investment reversibility and is zero when investment is perfectly reversible. Copyright The Econometric Society 2008.

Previous research has argued that debt financing affects equity-holders ’ investment decisions, producing substantial inefficiency. This paper shows that the size of this inefficiency depends on the degree of investment reversibility. In a dynamic model of financing and in-vestment, the paper provides an upper bound for the inefficiency pro-duced by debt financing. The upper bound is decreasing in the degree of investment reversibility and is zero when investment is perfectly reversible.

We investigate the strategic role of a recommender who cares about accuracy and whose recommendations influence product quality. In the presence of such feedback effects, recommendations have a self-fulling property: the recommendation agent can select any firm that will end up being the firm with the best quality. This produces important inefficiencies that include (a) a lack of incentive to acquire valuable information, (b) a status quo bias, and (c) the avoidance of risky innovations. Monetary payments from firms may work in mitigating these inefficiencies, while competition between recommenders and monetary payments from consumers are ineffective.

Investor sophistication has lagged behind the growing complexity of retail financial markets. To explore this, we develop a dynamic model to study the interaction between obfuscation and investor sophistication in mutual fund markets. Taking into account different learning mechanisms within the investor population, we characterize the optimal timing of obfuscation for financial institutions who offer retail products. We show that educational initiatives that are directed to facilitate learning by investors may induce providers to increase wasteful obfuscation, further disorienting investors and decreasing overall welfare. Obfuscation decreases with competition among firms, since the information rents from obfuscation dissipate as each institution attracts a smaller market share.

We introduce a simple model of the “percolation ” of information of common interest through a large market, as agents encounter each other over time and reveal information to each other, some of which they may have received earlier from other agents. We are particularly interested in the evolution over time of the cross-sectional distribution in the population of the posterior probability assignments of the various agents. We provide a market example based on privately held auctions, and show how the rate of convergence of the cross-sectional distribution of information is determined by the frequency of auctions and by the number of agents bidding at each auction. Our results contribute to the literature on information transmission in markets. Hayek (1945) argues that markets allow information that is dispersed in a population to be revealed through prices. Grossman’s (1981) notion of a rational-expectations equilibrium formalizes this idea in a centralized market. A number of important markets, however, are decentralized. These include over-the-counter markets and private-auction markets. Wolinsky (1990) and Blouin and Serrano (2002) study information transmission in decentralized markets. 2 In contrast to these two papers, equilibrium behavior in our market example leads to full revelation of information

We develop a theoretical model to analyze the effects of libertarian paternalism on information production and financial decision making. Individuals in our model appreciate the information content of the recommendations made by a social planner. This affects their incentive to gather information, and in turn the speed at which information spreads across market participants, via social learning or formal advice channels. We characterize situations in which libertarian paternalism improves welfare and contrast them with scenarios in which this policy is suboptimal because of its negative impact on the production and propagation of information.

Much research has suggested that independent boards of directors are more effective in reducing agency costs and improving firm governance. How they influence innovation is less clear. Relying on regulatory changes, we show that firms that transition to independent boards focus on more crowded and familiar areas of technology. They patent and claim more and receive more total future citations to their patents. However, the citation increase comes mainly from incremental patents in the middle of the citation distribution; the numbers of uncited and highly cited patents—arguably associated with riskier innovation strategies—do not change significantly.

Unlike labor income, human capital is inseparable from individuals and does not completely accrue to creditors. Therefore, human capital investment is more resilient to “debt overhang” than labor supply. We develop a dynamic model displaying this difference. We find that while both labor supply and human capital investment are hump-shaped in household indebtedness, human capital investment declines less aggressively as indebtedness builds up. Importantly, because human capital is only valuable when households expect to supply labor, the greater reduction in labor supply due to debt overhang back-propagates into ex-ante human capital investment. We provide empirical support for the model.