Word-of-mouth communication, noise-driven volatility, and public disclosure

Abstract

This paper examines how a firm adjusts its disclosure quality in response to technological innovations that improve investors' private information. We show that more precise private information can endogenously amplify supply shocks and, hence, increase noise-driven (or non-fundamental) price volatility. We study how the firm reacts to such changes and derive a necessary and sufficient condition under which the firm improves its disclosure quality when investors are informed with better private signals. We then apply our model to study investors' private word-of-mouth communication. Our analysis highlights a “dark side” of word-of-mouth communication and a call for better public disclosure even if private communication is assumed to be unbiased and truthful. We provide empirical predictions regarding how price volatility, market depth, and firms’ disclosure qualities would change as technological innovations, such as social media, facilitate information sharing among investors.