Incomplete Information and Irreversible Investment

Adams, Jonathan; Chen, Cheng; Fang, Min; Hattori, Takahiro; Rojas, Eugenio

doi:10.18651/RWP2025-11

Working Paper

Incomplete Information and Irreversible Investment

Abstract: How do information frictions and investment frictions interact? We use a continuous-time model to analytically characterize how incomplete information distorts firms’ decision rules and stationary distribution when investment is irreversible. The two frictions interact in rich and substantial ways. At the firm level, noisier information shrinks a firm’s inaction region and reduces the elasticity of investment to productivity. In the aggregate, incomplete information increases steady-state capital, exacerbates capital misallocation, and mitigates the impact of productivity shocks on aggregate investment. We test and quantify these predictions using Japanese administrative data that match firms’ forecasts with their balance sheets, incomes, and expenditures. In the data, firms underreact to news as if they face information frictions; those with more extreme underreaction are less inactive, as predicted.

JEL Classification: D25; D84; E22; E32;

https://doi.org/10.18651/RWP2025-11