Estimating Investor Demand Elasticity with Endogenous Firm Responses: Evidence from Mutual Fund Flow Shocks
This paper addresses an identification challenge in estimating investor demand elasticity: firms actively react to price pressures by adjusting equity issuance, creating endogenous feedback to firm value that biases traditional estimates. Using mutual fund flow shocks, I document that firms experience both positive stock returns and increased equity issuance following unexpected fund inflows. These price responses therefore reflect both exogenous demand pressure and endogenous improvements in fundamental value through strategic firm actions. To overcome this identification problem, I develop a dynamic structural model capturing strategic interactions among firms, mutual funds, and residual investors. Estimating the model via indirect inference, I find a price elasticity of 2.4 for residual investors-substantially higher than previous estimates that ignore firm responses. Counterfactual analyses reveal more moderate capital misallocation effects than prior literature suggests, as strategic interactions cause marginal price effects to diminish rapidly with the size of demand shocks.