Disclosure Decisions by Firms and the Competition for Price Efficiency

Abstract

This paper develops a model of the relationship between investment decisions by firms and the efficiency of the market prices of their securities. It is shown that more efficient security prices can lead to more efficient investment decisions. This provides firms with the incentive to increase price efficiency by voluntarily disclosing information about the firm. Disclosure decisions are studied. It is shown that firms may expend more resources on disclosure than is socially optimal. This is in contrast to the concern implicit in mandatory disclosure rules that firms will expend too few resources on disclosure.THIS PAPER DEVELOPS A model of the relationship between firms' investment decisions and the efficiency of the market prices of their securities. It is shown that more efficient security prices can lead to more efficient investment decisions. This provides firms with the incentive to increase price efficiency by voluntarily disclosing information about the firm. Disclosure decisions are studied.The costs of disclosure are twofold. First, there are costs of producing and disseminating the information. Included here are opportunity costs of firms' employees, auditing and legal expenses, costs of printing and distribution, and costs associated with the release of any proprietary information. Second, there are traders' costs of assimilating the information. For instance, while it is not very costly to obtain a firm's 8-K and 10-K (once produced), it is quite costly to understand the implications of their contents. While the former costs have been recognized in the literature on disclosure, the latter costs have not. That is, while traders are sometimes viewed as having access to some costly information, the information contained in firms' disclosures is typically taken to be costlessly observed by all (see for instance Diamond (1985) and Dye (1987)).1Taking traders' costs of learning the information content of firms' disclosures into account leads to new conclusions regarding incentives to expend resources on disclosure. In particular, it is shown that firms may spend more on disclosure than is socially optimal. This overdisclosure results from firms competing for the attention of traders. This is an interesting result given the public policy concern that firms, on their own, will spend less on disclosure than is socially optimal-* Kellogg Graduate School of Management, Northwestern University. We would like to thank Sugato Bhattacharyya, Doug Diamond, Bill Rogerson, Chester Spatt, and seminar participants at Columbia, MIT, Minnesota, and Wisconsin for helpful comments. The second author would like to thank the Banking Research Center at Northwestern University for financial support.' The distinction between producing and assimilating information is also made by Merton (1987).It is used to motivate the idea that firms have "limited investor bases," and the implications for asset pricing are analyzed. 634The Journal of Finance witness the enactment and survival of the Securities Act of 1933 and the Securities Exc...

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