Financial Disclosure, Knowledge Spillovers, and Corporate Innovation

Abstract

In this paper, I shed light on how financial disclosure impacts firms' incentives to innovate in an environment with knowledge spillovers across firms. Firms choose between using an old conventional method with a known success probability and using a new innovative method with an uncertain success probability. Importantly, each firm learns about the success probability of the new method over time by innovating, but also via other firms' financial disclosures. I highlight a tradeoff with respect to financial disclosure between firms' incentives to innovate and increasing learning across firms. I show that, when managers are non-myopic, a mandatory disclosure regime always dominates a no-disclosure regime because the benefit of learning across firms via knowledge spillovers outweighs the reduction in firms' incentives to innovate. However, when managers are myopic, financial disclosure entails an additional cost. Hence, a mandatory disclosure regime dominates a no-disclosure regime if and only if the expected future benefit of innovation is large. In addition, I also show that a voluntary disclosure regime with credible disclosures dominates a mandatory disclosure regime because it provides more incentives to firms to innovate and does not impair learning across firms.

Keywords: Innovation, exploration and exploitation, mandatory disclosure, voluntary disclosure, knowledge spillovers, free riding

JEL Classification: D38, M41, M48, O31, O32, O33