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Boom and Bust Patterns in the Adoption of Financial Innovations

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    We develop a dynamic model of the adoption of financial innovations. Each period, firms decide whether or not to adopt an innovation of uncertain value, and the profitability of each period's adoptions reveals information about the innovation's value. We show that characteristics of financial innovation waves cited by critics as evidence of irrational excess are, in fact, consistent with fully rational behavior. We also show that social welfare is enhanced when more firms adopt innovations of questionable value and that financial intermediaries have an incentive to encourage such adoption.

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    File URL: http://www.cob.ohio-state.edu/~fin/journal/dice/papers/1996/96-1.ps
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    Paper provided by Ohio State University in its series Research in Financial Economics with number 9601.

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    Handle: RePEc:wop:ohsrfe:9601
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    2. Robert S. Pindyck, 1990. "Irreversibility, Uncertainty, and Investment," NBER Working Papers 3307, National Bureau of Economic Research, Inc.
    3. Tsur, Yacov & Sternberg, Menachem & Hochman, Eithan, 1990. "Dynamic Modelling of Innovation Process Adoption with Risk Aversion and Learning," Oxford Economic Papers, Oxford University Press, vol. 42(2), pages 336-55, April.
    4. Jeremy Bulow & Paul Klemperer, 1991. "Rational Frenzies and Crashes," NBER Technical Working Papers 0112, National Bureau of Economic Research, Inc.
    5. Bhattacharya, Sudipto & Chatterjee, Kalyan & Samuelson, Larry, 1986. "Sequential Research and the Adoption of Innovations," Oxford Economic Papers, Oxford University Press, vol. 38(0), pages 219-43, Suppl. No.
    6. Sushil Bikhchandani & David Hirshleifer & Ivo Welch, 2010. "A theory of Fads, Fashion, Custom and cultural change as informational Cascades," Levine's Working Paper Archive 1193, David K. Levine.
    7. Michael C. Jensen, 1991. "Corporate Control And The Politics Of Finance," Journal of Applied Corporate Finance, Morgan Stanley, vol. 4(2), pages 13-34.
    8. Gorton, Gary, 1988. "Banking Panics and Business Cycles," Oxford Economic Papers, Oxford University Press, vol. 40(4), pages 751-81, December.
    9. Ben S. Bernanke, 1980. "Irreversibility, Uncertainty, and Cyclical Investment," NBER Working Papers 0502, National Bureau of Economic Research, Inc.
    10. Arrow, Kenneth J & Fisher, Anthony C, 1974. "Environmental Preservation, Uncertainty, and Irreversibility," The Quarterly Journal of Economics, MIT Press, vol. 88(2), pages 312-19, May.
    11. Miller, Merton H., 1986. "Financial Innovation: The Last Twenty Years and the Next," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 21(04), pages 459-471, December.
    12. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
    13. Banerjee, Abhijit V, 1992. "A Simple Model of Herd Behavior," The Quarterly Journal of Economics, MIT Press, vol. 107(3), pages 797-817, August.
    14. Tirole, Jean, 1982. "On the Possibility of Speculation under Rational Expectations," Econometrica, Econometric Society, vol. 50(5), pages 1163-81, September.
    15. Tufano, Peter, 1989. "Financial innovation and first-mover advantages," Journal of Financial Economics, Elsevier, vol. 25(2), pages 213-240, December.
    16. Jensen, Richard, 1982. "Adoption and diffusion of an innovation of uncertain profitability," Journal of Economic Theory, Elsevier, vol. 27(1), pages 182-193, June.
    17. Paul A. Samuelson, 1958. "An Exact Consumption-Loan Model of Interest with or without the Social Contrivance of Money," Journal of Political Economy, University of Chicago Press, vol. 66, pages 467.
    18. Hirshleifer, David & Subrahmanyam, Avanidhar & Titman, Sheridan, 1994. " Security Analysis and Trading Patterns When Some Investors Receive Information before Others," Journal of Finance, American Finance Association, vol. 49(5), pages 1665-98, December.
    19. Joseph Farrell & Garth Saloner, 1985. "Installed Base and Compatibility With Implications for Product Preannouncements," Working papers 385, Massachusetts Institute of Technology (MIT), Department of Economics.
    20. Katz, Michael L & Shapiro, Carl, 1986. "Technology Adoption in the Presence of Network Externalities," Journal of Political Economy, University of Chicago Press, vol. 94(4), pages 822-41, August.
    21. Allen, Franklin & Gorton, Gary, 1993. "Churning Bubbles," Review of Economic Studies, Wiley Blackwell, vol. 60(4), pages 813-36, October.
    22. Van Horne, James C, 1985. " Of Financial Innovations and Excesses," Journal of Finance, American Finance Association, vol. 40(3), pages 621-31, July.
    23. Rothschild, Michael & Stiglitz, Joseph E., 1970. "Increasing risk: I. A definition," Journal of Economic Theory, Elsevier, vol. 2(3), pages 225-243, September.
    24. Ross, Stephen A, 1989. " Institutional Markets, Financial Marketing, and Financial Innovation," Journal of Finance, American Finance Association, vol. 44(3), pages 541-56, July.
    25. Robert C. Merton, 1992. "Financial Innovation And Economic Performance," Journal of Applied Corporate Finance, Morgan Stanley, vol. 4(4), pages 12-22.
    26. Gul, Faruk & Lundholm, Russell, 1995. "Endogenous Timing and the Clustering of Agents' Decisions," Journal of Political Economy, University of Chicago Press, vol. 103(5), pages 1039-66, October.
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