The Role of Capital Market Settings in Disclosure Policy

Abstract

M y remarks concern the potential policy implications that arise from the relations among disclosure, cost of capital, and the nature of the capital market setting. My primary claim is that different capital market settings may yield different policy implications. For example, consider disclosure by an individual firm in a diversified market setting. That element of disclosure that provides information about the idiosyncratic behavior of the firm’s cash flow may have no relevance to policy makers in a market where idiosyncratic effects diversify away. Alternatively, that element that provides information about the systematic behavior of the firm’s cash flow may be relevant because it affects systematic risk. In other words, the policy implications of disclosure cannot be divorced from assumptions about the nature of the capital market setting where a firm’s shares are traded. With regard to capital market settings, one salient feature is whether the market is perfectly competitive, imperfectly competitive, or some mixture of the two. Most researchers in finance and accounting—to say nothing of most regulators—blur the distinction between perfect versus imperfect competition settings. This criticism is harsher still when researchers and regulators fail to make any distinction whatsoever. Despite this oversight, disclosure’s effects differ in perfect versus imperfect competition settings. These distinctions may have important policy implications. In perfectly competitive markets, each investor believes that his/her demand for an asset has no effect on the price at which his/her demand will be satisfied, and in equilibrium this belief is sustained. Perfect competition is consistent with markets that are deep, liquid, and attract many investors. In imperfectly competitive markets, each investor believes that his/her demand for an asset affects the price at which his/her demand will be satisfied, and in equilibrium this belief is sustained. Imperfect competition is consistent with markets that are not deep, illiquid, and attract relatively few investors.