#08-31
Illiquidity and Under-Valuation of Firms
Douglas Gale and Piero Gottardi, September 2008 8
Abstract: We study a competitive model in which debt-financed firms may default in some
states of nature. Incomplete markets prevent firms from hedging the risk of asset firesales
when markets are illiquid. This is the only friction in the model and the only cost
of default. The anticipation of such losses alone may distort firms’ investment decisions.
We characterize the conditions under which competitive equilibria are inefficient
and the form the inefficiency takes. We also show that endogenous financial crises may
arise as a result of pure sunspot events. Finally, we examine alternative interventions
to restore the efficiency of equilibria.
Keywords: illiquid markets, default, incomplete markets, price distortions, inefficient investment
JEL classifications: D5, D8, G1, G33
