Technological Innovation and Real Investment Booms and Busts

Technological Innovation and Real Investment Booms and Busts

By
Peter M. DeMarzo, Ron Kaniel, Ilan Kremer
Journal of Financial Economics.
2007, Vol. 85, Issue 3, Pages 735-754

We investigate why new, high-risk technologies can attract excessive and often unprofitable investment. We develop an equilibrium model in which rational, risk-averse agents overinvest in a risky technology, possibly to the point that its expected return is negative. Overinvestment results from relative wealth concerns which arise endogenously from the imperfect tradability of future endowments. Competition over future consumption leads to an indirect utility for wealth with “keeping up with the Joneses” properties that can induce herding. Because overinvestment increases with the risk of the technology, our model can explain why new, risky technological innovations may promote investment bubbles.