Informational Feedback Effect, Adverse Selection, and the Optimal Disclosure Policy

Trading in a secondary stock market not only redistributes wealth among investors but also generates information that guides subsequent real decisions. We provide a disclosure model that reflects both functions of the secondary market. By partially preempting traders' information advantage established from information acquisition, disclosure reduces incentives for private information acquisition. The resulting reduction in information acquisition has two opposite effects on firm value. On one hand, it narrows the information gap between informed and uninformed traders and improves the liquidity of firm shares. On the other hand, it reduces the informational feedback from the stock market to real decisions. The optimal disclosure policy is determined by the trade-off between liquidity enhancement and the investment efficiency. The model explains why the firm value could be higher in an environment that promotes disclosure and private information production at the same time and why growth firms are endogenously more opaque than value firms.