Previously circulated as “Estimating Investor Demand Elasticity with Endogenous Firm Responses”
Investor demand elasticity shapes how much stock prices move when demand shifts, and whether those moves distort real investment. I study how firms’ endogenous responses to demand shocks affect the measurement of the elasticity and capital misallocation. Empirically, a one-standard-deviation demand shock from mutual fund flows raises stock prices by 1.9%, and firms respond by issuing equity, raising investment, and paying down debt. This issuance absorbs part of the demand-driven price pressure, and investing the proceeds raises the firm’s fundamental value but can also misallocate capital. I estimate a dynamic equilibrium model on these responses and find three results. First, standard estimates count the change in fundamental value, 17% of the initial price response, as price pressure, and so understate the average demand elasticity. Second, no single elasticity is enough: how investors and firms respond depends on the source of the price change, the size of the shock, and the state of the firm. Third, even after this correction, demand remains far from perfectly elastic, yet demand shocks misallocate little capital: eliminating price pressure entirely raises aggregate TFP by less than a modest reduction in real capital adjustment costs. The same source-, size-, and state-dependent responses also limit this misallocation.
