Journal of Accounting and Economics 12 (1990) 219-243.

North-Holland

FINANCIAL DISCLOSURE POLICY IN AN ENTRY GAME*

Masako N. DARROUGH
Columbia University, New York, NY 10027, USA

Neal M. STOUGHTON
Universiv

of California at Irvine, Irvine,

CA 92717, USA

Received July 1988, final version received June 1989

This paper analyzes incentives for voluntary disclosure of proprietary information. Proprietary
information, if disclosed, provides strategic information to potential competitors, but can be
helpful to the financial market in valuing the firm more accurately. Focusing on a stylized model
of a static entry game, we show that a fully revealing disclosure equilibrium exists when the prior
of the market is optimistic or the entry cost is relatively low. When the prior is pessimistic or the
entry cost is high, however, both non- and partial-disclosure equilibria obtain. Our analysis
predicts that competition in the product market encourages voluntary disclosure.

1. Introduction
This paper analyzes voluntary disclosure of proprietary information. An
established incumbent firm is endowed with private information. If disclosed,
the information will help the financial market in evaluating the firms value
more accurately; the disclosure, however, could compromise the incumbents
competitive position. by providing strategic information to potential competitors. We focus on a relatively stylized model of a static entry game, where the
cost of disclosing proprietary information takes the form of an increased
probability of entry. Our model endogenizes the cost by making the probability of entry an optimal choice on the part of the entrant. The incentives are
countervailing. An incumbent with favorable information wishes to communicate the information to the financial market to raise its valuation, but otherwise does not want to make this known to the potential entrant. An incumbent
*A substantial portion of this research project was carried out while both authors visited the
Anderson Graduate School of Management at UCLA. The second author acknowledges a faculty
fellowship provided by the University of California at Irvine. We would like to thank Yuk-Shee
Chars. Jerry Feltham, Ron Giammarino, Don Kirk, Vojislav Maksimovic, Henry McMillan, Eric
Rasmusen, Michael &linger, Tom Russell, Robert Verrecchia (the referee), and participants in the
seminars at Columbia, University of British Columbia, Indiana University, University of Rochester,
University of California at Berkeley, Rutgers, and Stanford for helpful comments.
01654101/90/$3.500

1990. Elsevier Science Publishers B.V. (North-Holland)

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M. N. Darrough and N. M. Stoughton, Entry andjinancial

disclapure

with unfavorable information, on the other hand, would rather not disclose
this to the financial market, yet may want to communicate this to the potential
entrant to discourage entry. The financial market, of course, has rational
expectations taking into account the impact of their conjecture on the firms
incentive to disclose and the entrants reaction in the product market. A
possible scenario we identify is as follows: an incumbent voluntarily discloses
unfavorable information to discourage entry, yet the financial market reacts
positively.
Three players (the incumbent firm, the potential entrant, and the financial
market) are needed to analyze the conflicting incentives to disclose. The initial
literature on disclosure [Grossman (1981) and Milgrom (1981)] focusses on a
situation without the potential entrant, where the incumbent is only concerned
with financial market valuation. In this case the impetus for disclosure is
provided by the incumbents with favorable information. The only equilibrium
is one of full disclosure. Without the financial market, but with a potential
entrant, it is easy to see that the only equilibrium is again one of full
disclosure. In this case the impetus for disclosure comes from incumbents
with unfavorable information who maximize their intrinsic value by deterring
entry. When all three players are considered simultaneously, the possibility
arises of partial disclosure and nondisclosure equilibria because of the conflicting objectives of incumbents with favorable and unfavorable information.
Three equilibria are identified as follows:
l

A disclosure equilibrium in which private information is disclosed (and

entry depends on the information),
A nondisclosure equilibrium in which private information is not disclosed
(and entry does not take place),
A partial disclosure equilibrium in which favorable information is never
disclosed, but unfavorable information is sometimes disclosed (and entry is
random).

The first equilibrium obtains regardless of the prior beliefs, while the second
and third occur only when the prior is pessimistic or the entry cost is relatively
high.
Issues related to disclosure policy have been examined in various contexts
[Dye (1985a,b, 1986), Hughes (1986)]. Three papers that are closer to the
present paper are Verrecchia (1983), Bhattacharya and Ritter (1983), and
Gertner et al. (1988). Verrecchia considers whether a manager exercises
discretion in disclosing or withholding information in the presence of traders
For models of this sort see Vives (1984) and Gal-Or (1985, 1986).

MN.

Darrough and N. M. Stoughton,Entry and@ncial

disclosure

221

who have rational expectations about his motivation. The managers decision
is based on the effect of information on the assets market price. Assuming an
exogenously determined proprietary cost, the threshold level of disclosure is
shown to be positively correlated to the proprietary cost. Thus, Verrecchia
suggests that the nature of competition is important in determining the level of
disclosure. He states:
Firms in less competitive industries may see no costs associated with
making public disclosures. The corollary suggests that the greater the
proprietary cost associated with the disclosure of information, the less
negatively traders react to the withholding of information.
Verrecchia concludes, therefore, that product market competition may provide
disincentives for voluntary disclosure. Although this conclusion has an intuitive appeal, our model will suggest a rather different implication concerning
the disclosure policy of a firm facing a threat of entry. In our model, when the
prior is optimistic or the entry cost is relatively low, the unique equilibrium is
that of full disclosure. In other words, full disclosure takes place when the
market condition is favorable enough to support two firms. This occurs
because the motive for entry deterrence becomes dominant for an incumbent
with favorable information. We would expect that lower costs of entry are
associated with greater competitive pressures. Thus our model predicts that
competition encourages voluntary disclosure.
Bhattacharya and Ritter (BR) model a winner take all innovation game. A
tirm with superior information decides on the level of disclosure taking into
account the impact on the financial market in raising the necessary capital as
well as the impact of the rivals success probability in a R&D race. Although
entry is endogenous in the BR model, exogenous costs are also imposed. By
contrast, our model is game-theoretic and costs are endogenous. The Gertner
et al. article is chiefly concerned with a theory of capital structure. An
important difference between our model and theirs is that we assume truthful
disclosure instead of constraining the contract process by this requirement.
Although we label specific variables as private information, our motivation
is quite general. Almost any information voluntarily revealed through formal
or informal channels, such as financial statements, press conferences, or
discussions with reporters, can have strategic implications. Even a discussion
on the nature of R&D, future plans, or a management earnings forecast often
reveals useful information to competitors. This might be the reason why few
American corporations provide management forecasts.
The paper is organized as follows. The next section deals with the description of the game. The game is then analyzed in section 3, and equilibria are
derived in section 4. The fifth section discusses the interpretation of these
equilibria. The paper closes with a discussion and conclusion.

J.A.E.-H

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M. N. Durrough und NM

Stoughton,Entry andfinancial disclasure

2. Description of the game

We now present a formal model to describe the game among the incumbent
monopolist (I), the financial market, and the potential entrant (E). The
model consists of two dates and one period. At time zero, the incumbent raises
$K from the financial market by selling a portion of the fhm2 The terms of
financing are influenced by the disclosure (or lack thereof) of the incumbents
private information, as is the potential entrants decision. If entry takes place,
a duopoly game is played at the end of the first period.3 Entry incurs a cost of
$K,. Since the entrant does not have any private information, the method of
financing is of no consequence. Upon entry, the entrant becomes informed,
even if no disclosure was made by the incumbent.
Before we can analyze the strategies of the incumbent and the potential
entrant, it is necessary to specify in detail the payoffs of the players in the
game. First it is necessary to understand how revelation of the private
information affects the profits of the duopolists in the post-entry game. It is
convenient to classify the incumbent information as favorable or unfavorable from the viewpoint of the potential entrant. We then explain the
assumptions that were made as to the partial ordering of profits associated
with different outcomes of the game. Finally, strategies of the players are
defined to conclude the description of the game.
2.1. Informational consequences of the post-entry game
Consider the post-entry subgame. Upon entry, the entrant learns the private
information (regardless of whether the private information was actually disclosed or withheld by the incumbent). The entrant then makes the optimal
output decision to share the market with the incumbent. Favorable (good)
news is defined as follows:
If the effect of a change in a parameter value (or collection of
parameter values) is to increase the realized profits of both the incumbent and
entrant in the post-entry game, then this is fauorable news.

Dejinition.

The news is unambiguously favorable to the entrant.

contemplating whether to disclose at a pre-entry
increase the probability of entry of the potential
situation, the incumbent is reluctant to release the

For the incumbent who is

stage, the disclosure will
entrant. Thus in such a
private information. This

The financing method is equity issuance: in particular, we assume that the firm is not able to
borrow funds (either privately or publicly).
This differs somewhat from the conventional entry game in which the incumbent is a
monopolist in the first period and its product market behavior in the first period afkcts the
entrants behavior in the second period.

M.N.

Darrough and N. M. Stoughton, Entry and financial

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223

illustrates that a conflict of interest concerning disclosure by the incumbent

arises when the news affects the profits of the two firms in the same direction
in the post-entry game. Such a conflict does not arise when the profits of the
incumbent and entrant move in opposite directions. The incumbent is pleased
to disclose such news, since it not only increases financial market valuation,
but also discourages entry. Therefore, a nontrivial disclosure problem exists
only if information fits our definition of favorable news.
For illustration, in the appendix, we formulate a post-entry subgame based
on Cournot-Nash
behavior with linear demand and cost functions. The
incumbent and the entrant are assumed to sell differentiated products in the
same market. We show that an increase in the value of the demand intercept
raises the equilibrium profits of both duopolists and therefore fits our definition of favorable news. It can also be seen that the slope of the demand curve
and the coefficient of differentiation affect the profits of duopolists in the same
direction: the flatter the demand curve, the higher the profits; the more
differentiated the products, the higher the profits.
The impact of production cost, on the other hand, is different. If costs are
independent, a lower marginal cost of the incumbent increases its own profit
but decreases the entrants profit, ceteris paribm4 There are no tradeoffs to
worry about. The potential entrant, not having entered in the market, might
not know its marginal cost. If there is a positive correlation between the costs
of the two firms, low cost of the incumbent is favorable news to the entrant,
since the profits of the two firms move in the same direction.5
By looking at the sign of these comparative statics, we classify the information into favorable and unfavorable news. This classification is based on the
impact of information on the entrants profitability. For the potential entrant,
entry is more profitable under a favorable condition and is less profitable
under an unfavorable condition. The incumbent, on the other hand, has to
consider the tradeoffs between the impact on the entry behavior as well as the
financial market reaction. The financial market in turn would value the
incumbent by assessing the strategies of both the incumbent and the entrant.
It should be emphasized that the qualitative analysis and predictions of our
model do not depend on the Coumot structure. They do assume, however, that
the post-entry game does not degenerate to a situation in which profits are
driven down so low that entry is never warranted.
2.2. Partial ordering of projits
Now that favorable and unfavorable news are defined, we relate the duopoly
profit levels to those of the disclosure/entry game. The incumbent is con-

4This is

the case analyzed by Milgrom and Roberts (1982) in the context of limit pricing.

Harrington (1986) analyzes this case to show that the monopolist

than the monopoly price.

may charge a higher price

M. N. Darrough and N. M. Stough~on,Entry ond financial discloswe

224

cemed with the two effects of disclosure, since entry reduces its profit but it
needs financing from the financial market. We assume that the private information parameters take on two possible values, H or L (high or low). For ease
of exposition, we refer to the incumbent with favorable information as type H
and the one with unfavorable information as type L. These values are
common knowledge. Thus the following notation is used to represent the
(actual or intrinsic) profit levels of the incumbent (I) and the potential entrant
(E) when the private information is favorable or unfavorable.

i9
ni?

i = M, I, E,

the profit of monopolist (M), incumbent (I), and entrant

(E) under duopoly when the condition is favorable,

i = M, I, E,

the profit of monopolist (M), incumbent (I), and entrant

(E) under duopoly when the condition is unfavorable.

These definitions imply that

i7; > ai?

i=M,Z,

E.

For the potential entrant to have a nontrivial entry problem, we assume

that:
[Al]

?i,>&>&o.

This guarantees that if a disclosure of unfavorable information is made, the

potential entrant will stay out but will surely enter if a disclosure of favorable
information is made.
What is nor implied by our definition is the relation between II, and fi,. It
turns out that these two values are critical in the disclosure/entry
game.
Therefore we need to understand what this relation implies. Two possibilities
exist:
[A21

II., 2 ?I,,

[A21C

II., < ?i,.

Hence, [A21 implies that ii,,, > II., 2 n, > II,, whereas [A2] implies ni, >
n, > II., > II,. This can be interpreted as a condition on (1) *how the two
types differ as well as (2) how the industrial structure affects the incumbent
profits. Since [A21 states that monopoly profits are higher for each type, we
can view this as a situation where the type difference is less signil%ant than the
difference in the industrial structure. Under [A21C, since the high type profits

M. N, Durrough and N. hf. Stoughton, Entry andjnanciaf

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225

are higher regardless of the industrial structure, this is a situation where the
type difference is more significant6
Our intuition suggests that when the type difference is more significant, the
motive for type H to be evaluated correctly by the financial market outweighs
the motive for preventing entry. This encourages disclosure. Type L is subject
to different motives. They would rather hide their information, in which they
might succeed if they choose nondisclosure. (Of course, they would be successful only if the H type also followed a nondisclosure policy.) When the
industrial structure is more important, prevention of entry becomes the crucial
consideration. The L type reveals itself to discourage entry, whereas the only
hope for H is through nondisclosure. Our main results in the next sections rely
on [A21 (as a sufficient condition). To be complete, we also present a discussion on the implications of [A21c.
The third assumption guarantees that at least the incumbent will remain in
the industry even under unfavorable conditions. Moreover, this assumes that
the investment opportunity always has positive net present value in a world of
complete information:

[A31

fi,>I7,>

K>O.

Finally, we make the following important assumption:

[A4]

Disclosure is truthful and costless.

The truthful disclosure assumption simplifies our analysis and is common to

most disclosure models. It is reasonable if the disclosed information is audited
or verifiable. *s It is also a necessary condition to get existence of a full
disclosure equilibrium in our model.
This also implies that a game-theoretic analysis predicated on [AZ] may not be robust with
respect to an increase in the number of types. Specifically, [A21 may be indicative of what one
would get in a model with a continuum of types.
If disclosure cannot be credible, then the firms may attempt to communicate their type through
other signals such as capital structure.
*If disclosures require a fixed amount of administrative costs, then firms will not be indifferent
between disclosure and nondisclosure when they are identified anyway. Type H in Proposition 1
will strictly prefer nondisclosure to disclosure. The nature of tradeoffs and equilibria, however, is
not at&&xl by the assumption of a fixed disclosure cost.
91t can be shown that [A41 is not needed in the following circumstanoe. If [AZ) holds and the
intrinsic value of a H type firm that falsely declares low is depleted by the amount of the
misrepresentation, then outright lies become dominated strategies for the incumbent types.

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M. N. Durrough and N. M. Stoughton,Entry and financial disclosure

2.3. Definition of strategies

Disclosure policy for the incumbent is defined aslo

d, =s(d=HIH),

d,=B(d=LIL),

where d, (d2) represents the probability that disclosure is made given that the
incumbents private information is H (L).
Entry policy of the entraint is
e=P(entryId=ND),
where e represents the probability of entry when no disclosure was made.
Assumptions [Al] and [A41 imply that the potential entrant will enter when
d = H and will not enter when d = L with probability one. The structure of
beliefs by the two parties is denoted by

p=9(H),

q=g(Hld=iVD),

where p, 0 -Cp -C1, is the prior belief and q is the posterior belief of the
financial market and the entrant upon observing no disclosure. Again the
assumption of truthful disclosure implies that the posterior beliefs must be
that the incumbent is type H when d = H and type L when d = L. The
extensive form of the game is given in fig. 1 along with profits for incumbent
and entrant (without explicit depiction of the financial market). Note, however, that Zs profit represents (actual) intrinsic value (and not the payoff
function).
3. Strategic analysis
The equilibrium concept we employ is sequential equilibrium due to Kreps
and Wilson (1982). The game is defined by the extensive form in fig. 1 plus the
common knowledge information, p, the prior belief of the financial market
and the entrant as to the type of the incumbent. Using the definitions
contained in the previous section regarding entry and disclosure policy, a
sequential equilibrium is defined by

(d,,d,,e,q}.
Furthermore, the posterior beliefs in the information set must satisfy the
Bayes consistency requirement as long as the denominator of the following
9

denotes probability.

M. N. Durrough and N. M. Stoughton, Entry and financial disclosure

Dimehum

Entrants

Policy

Policy

Ir Proa
(Actual)

221
Er Pro5t
(Actud)

Fig. 1. Extensive form.

expression is positive:

Al - 4)
q= T(l

- d,) + (1 -p)(l

-d*)

(1)

In order to determine the set of sequential equilibria, first we investigate the

entrants best responses conditional on their beliefs. We then analyze the
incumbents disclosure strategy {d,, d,} as a function of the entrants entry
response function and financial market valuation. Results are then combined
to find necessary conditions on the common knowledge parameters that
support the various types of equilibria and on endogenous beliefs, q.

228

M.N. DorroughOIK/N.M. Stoughron,Entryondjnoncioi oYsciloure

3. I. Entrants strategy

If entrants observe a favorable disclosure, d = H, they will enter for sure,

while they will stay out upon observing d = L. This is due to the assumption
that disclosure is always truthful and that the entrants actual profit is positive
only when the market condition is favorable, [Al]. When the incumbent does
not disclose, however, the entrant policy depends upon the expected payoffs,
E(n,lQND), where ad, d E {D, ND}, is the information set with s2* representing information with disclosure and QND without disclosure. Entry takes
place if the expected profit is strictly positive, i.e.,

or

(2)
where 0 < p < 1 using [Al]. The value of p can be interpreted as the relative
cost of entry.
In summary, the entrant strategy is as follows:
e=l

4PcL,

(3)
(4)

e=O

3.2. IncumbentS

q<p.

(5)

strategy

The objective of the incumbent is to maximize the expected value of the ex

shareholders wealth by choosing an optimal disclosure policy. To
engage in a new investment project, the incumbent has to sell shares to raise
$K. The higher the financial markets valuation of the firm, the less needs to be
sold to raise the given amount of financing. If a(d) represents the fraction of
the firm that must be sold on the financial market conditional on disclosure
policy, d, then a(d) = K/V(d),
where V(d) is the markets conditional
valuation. Given the financial markets rational expectations,
V(d) =

ante

This form of objective function was used in Bhattacharya and Ritter (1983) and in John and
Williams (1985). Another popular objective function is the maximization of a weighted average of
current and future share prices. This latter objective function appeared in Miller and Rock (1985)
and was also used in Ambarish (1988). We have chosen the former approach rather than the latter
because this objective is endogenously derived from the need to raise external financing rather
than being postulated as arising from exogenous forces.

M. N. Darrough and N. M. Stoughton,Entry and jnancial dischue

229

E(Z7,lP, e), the expected profit of the incumbent conditioned on the inforrnation set and entry policy. M aximization of shareholder value amounts to
multiplying the retained ownership fraction, 1 - (Y,times the intrinsic expected
profit from the informed incumbents point of view, E(If,la, e), D E {H, L}.
Therefore the objective is

When disclosure is truthful, the objective function can be simplified since

K

- E( II,lP,

e)

E(fl,lfi,

e) = E(fl,lQ,

e) - K,

when d = D. Moreover, if the incumbent follows a pure disclosure strategy,

then it is simple to compute the actual payoffs of the game. Any complication
in analyzing the game, therefore, arises from the possibilities of nondisclosure
as well as mixed strategies. Since the entrants strategy depends on the
posterior, the incumbents strategies must be analyzed for each posterior (upon
no disclosure) in order to derive all the potential equilibria. Given the
entrants strategy and the financial markets rational expectations, the incumbent decides whether to disclose. Benefits and costs of disclosure depend upon
the private information (or type). These are as follows:
For H, disclosure will identify their type, inducing entry as well as correct
valuation. Thus, incumbents will receive

TI,- K,

(6)

the profit from the duopoly game minus the portion of the firm sold to the new
shareholders. If they choose not to disclose, then they will be valued in a
pooled fashion, i.e.,

l-;

?i,+(l-e)
1

l--F.I?,,
1

where

If the net benefit is positive, (6) greater than (7), then H will disclose.

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M. N. Durrough and N. M. Stoughton. Entry and financial diselapure

The same logic applies to L. The benefit from disclosure is prevention of

entry, resulting in the monopoly profit of

&f--K,

(8)

while by not disclosing they would be pooled as in (7). In other words,

nondisclosure gives both types the same market valuation, but disclosure has
different benefits. Whether or not disclosure takes place depends on whether
or not net benefit is positive. Under assumption [A2], II, > ?I,. This implies
that if both types disclose in equilibrium, the low type has a higher monopoly
profit than the high type as a duopolist.

4. Equilibrium
We now examine equilibria of the game. The following analysis is based on
the assumption that [A21 holds. As discussed earlier, this is a situation in
which the type difference is not as significant as the difference in the industrial
structure. Three types of equilibria are identified: (1) both types disclose when
the costs of entry are low and/or the prior is relatively optimistic; (2) neither
discloses when the prior is relatively pessimistic and/or the entry costs are
high; and (3) in addition, there is a mixed strategy equilibrium under the same
conditions as (2). When both types disclose, their types are clearly revealed.
This kind of separating equilibrium is referred to as a disclosure equilibrium.
The second equilibrium is called a nondisclosure equilibrium. We start our
discussion with the disclosure equilibrium.
Proposition I. Under assumption [AZ], there exists a set of sequential equilibria
that are observationally equivalent to a disclosure equilibrium in which both types
disclose. Entry occurs for certain in the event of ND. Symbolically,

{d,E[0,1],d2=1,e=1}.

Moreover,

when p > u, this is the unique sequential equilibrium outcome.

The proof shows that these constitute best responses of the players
given the equilibrium strategies of the other players. In addition, they must be
sequentially rational. We can show that a consistent belief is q = 1. This
requires showing that both types of incumbent prefer disclosure, when e = 1
and the financial market reacts rationally.

Proof.

M, N. Durrough and N. M. Sloughton, Entry andjinancial

disclawre

231

If the incumbent is of type L, I still prefers disclosure if expected profit

from disclosure is higher than that under a nondisclosure policy, i.e.,

where

n,.

(10)

The left-hand side of (9) represents the expected profit when d = L, whereas
the right-hand side represents the expected profit when d = ND. Rewriting the
inequality, we obtain

This may be rearranged to yield

(11)
Given [A2], a,., 2 n, is sufficient for (II, - &)/(fi,
- II,) 2 1, which in
turn implies the above inequality in conjunction with [A3]. In fact, the low
type strictly prefers to disclose.
If the incumbent is of type H, then disclosure is followed by certain entry.
Hence this type of incumbent is indifferent between disclosure and no disclosure with e = 1. This supports the proposed equilibrium.
In addition, it can be shown that posterior beliefs p < q < 1 are also
consistent with the disclosure equilibrium where d, = 1, since the high type
has a strict incentive to disclose in this case. (If the high type chose ND, then
valuation would be less but there would still be a certainty of entry.) With the
above beliefs, the low type still prefers disclosure. This is because under [A2],
we have just shown that the low type prefers disclosure when ND prompts
valuation as the high type; hence lower valuation cannot make the low type
better off. Finally, the uniqueness question must be addressed. This follows
from the following three propositions which collectively verify that if [A21
holds, the only other sequential equilibria require p 5 p. l

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M. N, Durrough and N. M. Stoughton, Entry andjinancial

disclosure

The disclosure equilibrium above is supported by a prior that is optimistic

compared to the relative cost of entry, p. Notice that Proposition 1 identifies
an equivalence class of equilibria in that the type always is identified. That is,
although the set of equilibrium actions is nonunique, the equilibrium outcome
is nevertheless unique. * When both d, = d, = 1, Bayes theorem cannot be
applied. However, this equilibrium point is connected to the strictly randomized points, which imply that posterior beliefs are that the type is high upon
nondisclosure. This means that the equilibria in Proposition 1 are part of a
stable set as Kohlberg and Mertens (1986) have defined; furthermore, refinements such as the intuitive criterion [Cho and Kreps (1987)] and universal
divinity [Banks and Sobel(1987)] will never eliminate the disclosure equilibria.
Since the disclosure equilibrium is the only potential equilibrium where there
is freedom to choose off-equilibrium beliefs, these refinement concepts are
powerless in our model with respect to eliminating multiple equilibria. The
equilibrium requires that q > cc, implying that the posterior must be optimistic
but no restrictions are imposed on the prior. Since there could be other
equilibria when p I CL, the disclosure equilibrium uniquely obtains when
p > p. This disclosure equilibrium is robust under assumption [A2].
An interesting. market reaction is implied under [A21 in the disclosure
equilibrium. For a type L firm, since the disclosure prevents entry, the market
values the firm as 0,. For a high type firm, the market values the firm as n,.
Under [A2], these ex post values are & 2 ?I,, so that the price response to
unfavorable information involves an increase, while prices decrease when
favorable information is disclosed.
When the market is pessimistic, however, the H type may decide not to
disclose since this discourages entry. The L type may also find it advantageous
not to disclose, since it does not have to worry about discouraging entry (by
disclosing its L type) and can hide behind no disclosure to obtain better
financing terms by being pooled with the high type. Thus, we can have the
following equilibrium:
Proposition 2. Given [AZ], there exists a nondisclosure sequential equilibrium in
which both types choose not to disclose if and only if p < PL:
{d,=O,d,=O,e=O}.

Proof. Clearly the nondisclosure equilibrium requires that prior beliefs equal
posterior beliefs. To support no entry implies that p = q < c. Given e = 0, the
12Such multiplicities are innocuous. For example, they are also present in the models of
Grossman (1981) and Milgrom (1981).

M. N. Durrough and N. M. Stoughton,Entry andfinancial disclosure

233

high type of incumbent prefers ND if

l-f

n,rn,-K.
i

This can be rearranged to give the equivalent condition

02)
Assumption [A21 implies that i?, 5 Q,,, < V, so that assumption [A31 is
sufficient to imply (12). Since entry will not occur for the low type upon
disclosure, this type benefits from higher financial market valuation. Choosing
n
ND is therefore consistent with sequential rationality.
For type H, discouraging entry (by providing no information) is more
important than being correctly evaluated by the financial market. Of course,
the H types cannot differentiate themselves from the L types. The L types are
definitely better off, since they receive higher valuation by the financial
market, and face no possibility of entry - the L types are free-riders here.
Given the no-disclosure policy of the two types, {d, = 0, d, = 0}, the entrant
and the financial market update their prior as

= ~(1 - d,)

+ (1 -p)(l

- d2)

=*

which shows that the entrants pessimism originates from their prior as to the
incumbent type. When the market and the entrant do not suspect that the
incumbent is likely to have favorable news, the H type would rather hide
behind the veil of pessimism.
What kind of equilibrium could obtain when the posterior is totally pessimistic, or q = O? Then, since no disclosure discourages entry for sure, even
the H type is willing to forgo correct evaluation from the financial market, as
in the last case. On the other hand, since no entry takes place whether they
disclose or not, type L will be indifferent between disclosure and no disclosure. It might appear that {d, = 0, d, E (O,l)} is a potential equilibrium.
However, this is not sequentially consistent, since q cannot be zero given these
disclosure policies.
Propositions 1 and 2 considered the cases where q > p and q < p, respectively. We are left with the situation when q = p. This is a case in which the
entrant might pursue a mixed strategy upon observing no disclosure, since the
expected value of entry is zero. It can be shown that an equilibrium exists in

234

M. N. Dmrough and N. M. Stoughton, Enty

andfiMncia1

disclosure

which one type of incumbent randomizes and the other does not disclose. It is
not possible to have an equilibrium in which one randomizes and the other
discloses, since in that case q would have to be zero or one, which is a
contradiction to the hypothesis of q = p.
Proposition 3. Given [AZ], there exists a partial disclosure equilibrium in which
the high type chooses not to disclose, the low type randomizes and entry is random
when nondisclosure is observed if and only if p < p, i.e.,
d, = 0, d, = (l:;,p,

e = e* E (0,l)

.
I

i
Proof.

To support this mixed strategy equilibrium, the posterior beliefs upon

nondisclosure must leave the entrant indifferent. That is, q = ~1. Since in
this proposed equilibrium only the incumbent with favorable information
always chooses nondisclosure, the posterior belief, q, must be larger than the
prior, p. This yields the necessary condition that p > p. Notice that when
d, = (p - p)/(l - p)~, the posterior belief computed using Bayes rule is
P
P+

= El,

1 - (lp_-;)ll

(1 -P)

as indeed it should be.

Let e* denote the entry probability. The valuation of the financial market
after observing nondisclosure is then

v=e*(Q,+p(Ti,-l7,))

+(l -e*>(!Lf+P(nh4-hf))*

Since the L type incumbent is indifferent between disclosure and nondisclosure, the entry probability must be such that
l-5

l&-K=

(13)

(e*aI+(l-e*)a+,).
1

We claim that if [A21 is satisfied, there always exists an e* E (0,l) such that
equality in (13) is achieved. To verify this claim, note that if e* is one, then the
left-hand side of eq. (13) is greater than the right-hand side:

&J-K

l-

K
n,+,(j=j,-Q,)

n19

(14)

M. N. Darrough and N. hf. Stoughton, Entry andjinancial

disclosure

235

using [A2]. On the other hand, if e* is zero, then the left-hand side of (13)
would be less than the right-hand side since

By continuity of the right-hand side of (13) there exists an e* E (0,l) such

that (13) holds.
Now, we must verify that at e*, the H type strictly prefers nondisclosure to
disclosure. That is,
?f,-K<

l-;
i

(e*n,+(l-e*)?i,).
1

1- f

i
c

(e*III+

(1 - e*)II,)

(e*fi,+

(1 - e*)?I,),

i
1- ;

05)

which proves the result. The first inequality above follows from [A21 and the
equality comes from eq. (13). H
Notice that in this equilibrium, revelation of the type does take place with
positive probability. Thus when the low type happens to disclose, entry would
not ensue. When nothing is disclosed, however, entry might or might not
occur.
4.1. The financial market and [A2]
When [A21 does not hold, the above results are essentially unchanged as
long as the amount of external financing required, K, is relatively small. We
outline below how this claim can be.demonstrated in the above propositions.
With respect to the disclosure equilibrium (Proposition l), the key is that
the low type should not prefer ND and the consequent higher valuation. A
necessary condition for this is eq. (11). In this case, even if [A21C holds so that
II,)/(fi,
- II,) < 1, this is bounded away from zero so that (11) can
(&still be satisfied for low values of K.

236

M. N. Durrough and N. M. Stoughton,Entry andjnancial disclosure

Similar logic applies to Proposition 2. Here the critical incentive compatibility condition is (12). Once a@n, the right-hand side is strictly positive since
V < n, even though &, < l7, when [A21C is true. Therefore, the nondisclosure equilibrium will still exist when the external financing requirement is
sufficiently small.
For the mixed strategy equilibrium of Proposition 3, the results are similar.
Again the equilibrium will exist in the absence of [A21 if K is suitably chosen.
It can be seen that as K tends toward zero, the low type has to be indifferent,
which causes the equilibrium entry probability, e*, to approach zero. But this
lowering of the chance of entry encourages the high type to select nondisclosure and tends to uphold the equilibrium.
The intuitive argument for why the assumption of [A21 and low values of K
leads to similar predictions runs as follows. In the disclosure equilibrium, the
binding constraint is that the low type should resist the temptation of
garnering excessive financial market value at the expense of incurring entry.
Under [A2], the relative valuation gains are limited by the favorable position
of the low monopolist vis-&is the high duopolist. Alternatively, the potential
valuation gains can be limited by a modest external financing requirement. In
the nondisclosure equilibrium, the binding constraint is that the high type
should discourage entry by pooling with the low type. This requires the
acceptance of some amount of underpricing by the financial market. When
[A21 holds, the underpricing is limited by the favorable position enjoyed by the
low type monopolist. Alternatively, the disutility due to underpricing might be
limited by a small magnitude of external financing.
Another sufficient condition for the simultaneous existence of full, non, and
partial disclosure equilibria is that the incumbent and the entrant be similar.
In a Coumot or Stackelberg duopoly game, if there are homogeneous products
and identical costs, then it is easily shown that the bounds on K implied by
(ll), (12) and (14) are larger than II,. Thus, by [A3], the above equilibria
exist. The reason for this is that a very different entrant (e.g., low coefficient of
differentiation) implies that the profit of the incumbent is affected relatively
less by entry, and hence the threat of entry is not as important. The incumbent
then will care more about financial valuation than entry deterence - a similar
situation to K being large.
What happens when the equilibria of Propositions l-3 do not exist?
Although we believe that the economic environment required for Propositions
l-3 is more relevant, for the sake of completeness, a brief discussion is
provided on alternative equilibria. Interestingly enough, even when K is large
and [A21C is satisfied, there is existence of full disclosure. The following
proposition gives this result:
Proposition 4. Suppose that [AZ] hola!sand K is suficiently large. Then there
exists a disclosure equilibrium in which the high type discloses and the low type

M. N. Darrough and N. M. Stoughton,Entry andjinancial disclosure

231

randomizes. Upon nondisclosure, the entrant stays out, i.e.,

{d,=l,d,E[O,l],e=O}.

Proof. The low type is clearly indifferent between disclosing or not. Since
only the low type ever chooses nondisclosure, posterior beliefs can be q = 0,
which supports the decision not to enter. We only need to show that the high
type prefers to disclose. This is so if

This is equivalent to

It is easy to see that this holds only if K is sufIiciently large and [A21C is
satisfied. n
This proposition yields an equilibrium that is observationally equivalent to
that of Proposition 1. In both cases, the types are identitied and the entrant
enters if and only if information is favorable. Hence, full disclosure exists
either when [A21 is satisfied or the importance of the financial market is
significant. When [A2] is true but K is in some intermediate range, full
disclosure does not exist. When the market is optimistic, we can have a fourth
type of equilibrium involving a random disclosure policy by the high type and
no disclosure by the low type. Entry is also random following nondisclosure. It
can be shown again that this equilibrium exists only if [A21 is not satisfied and
K is sufficiently large. Only favorable information is ever disclosed.
Proposition 5.
d

exists

A sequential equilibrium involving the strategies:

d,=O,

e=e^E(O,l)

Pk-!4*

if and only if p

> ~1, [ A21C

06)

hol&, and K is suficiently large.

Proof. The requirement of posterior beliefs in this equilibrium is that p > IL,
since the high type is mixing and the posterior beliefs must satisfy q = p. It is
easily verified that the randomization probability prescribed above accomplishes the desired effect through Bayes rule.

238

M. N. Durrough and N. M. Stoughton, Entry and financial disclasure

We now demonstrate that this equilibrium cannot exist under [A2]. Denote
the convex combination of monopoly and duopoly profits of both types as
?I=li,C+(l-e^)?l,,

a=

I&s+

(1 - Z)l7,.

Then to support this equilibrium, we require as necessary that

holds for the high type, where V is the valuation given nondisclosure.
At the same time, the low type must have an incentive not to disclose so that

(17)
Suppose that [A21 is satisfied so that II, 2 ?Tr. Applying this to the two
previous equations we arrive at the conclusion that

But this implies that a 2 n which is a contradiction.

When [A21C holds, we can also derive a contradiction when K is sufficiently
small. The argument is as follows. Consider the indifference relation of the
high type. As K tends to zero, the probability of entry, P, must go to one. This
causes Q + II,. But then the incentive compatibility condition given by eq.
(17) failsbY&ause l7, < &.
n
The intuitive explanation is as follows. The low type has to strictly prefer
nondisclosure with the concomitant probability of entry. In order for this to
be the case, the low type must be compensated by higher valuation in the
event of nondisclosure. But if the types are close so that [A21 is satisfied, then
the high type will switch to nondisclosure. This occurs because undervaluation
is relatively unimportant given that entry is induced for sure upon disclosure,
but only randomly upon nondisclosure. Hence the potential equilibrium is
broken.
5. Discussion and conclusion
Under a condition which amounts to entry deterrence being more important
than financial valuation, we have identified three equilibria in the disclosure

M.N.

Darrough

and N. M. Stoughton,

Entry and financial disclosure

239

game: (1) a disclosure equilibrium in which both types disclose their types
when the prior is optimistic or the entry cost is relatively low; (2) a nondisclosure equilibrium in which neither type discloses when the prior is relatively
pessimistic or the entry cost is relatively high; and (3) a partial disclosure
equilibrium in which only unfavorable information is ever disclosed. In the
disclosure equilibrium, we also document the interesting effect that market
price reactions can be inversely related to the announcement of favorable or
unfavorable news. The entrant enters, however, if and only if the incumbent is
revealed to have favorable information. Entry probability, therefore, is exactly
the same as under full information. No entry deterrence takes place in
equilibrium. The equilibrium then would be considered socially desirable.
Since disclosure of proprietary information is made voluntarily, this suggests
that mandatory requirements for disclosure are not necessary in this case.
There appears to be a role in the accounting profession in facilitating truthful
disclosures through auditing to prevent falsehood.
When the prior is pessimistic relative to the cost of entry, since the threat of
entry is weak, firms might not disclose. Upon no disclosure, the entrant is
deterred from entry. This happens regardless of the nature of underlying
private information. Although the prior is relatively low, even socially desirable entry is prevented. Obviously the incumbent monopolist is better off, but
consumers and the potential entrant lose out. This result can be used as a
justification for a mandatory disclosure requirement of proprietary information. It might also provide a justification for the existence of private placements, as Campbell (1979) has observed.
An important implication of our model is that competition through threat of
entry encourages voluntary disclosure. Verrecchia, on the other hand, suggested that the less competitive industries are, the more disclosure takes place.
The source of differing conclusions appears to be the interpretation of competition and costs.13 In our paper, the question of obtaining a unique full
disclosure equilibrium depends on the relative entry costs. We conclude that
since low entry costs leads to a higher entry probability, full disclosure ensues
under competitive pressure. By contrast, consider a model in which there is a
set of rivals to an informed firm who have already entered. Then, the cost of
disclosure to an informed firm with favorable information is that it will induce
the rivals to produce more. It is possible that as the size of the set of rivals
increases, disclosure becomes more costly. If competitive situations are associated with greater numbers of rivals, then such a model might yield the
prediction that competition discourages voluntary disclosure. This might have
been what Verrecchia had in mind when he adopted the premise that the
proprietary costs of disclosure are greater in more competitive situations. In
both Verrecchias as well as our model, less disclosure is associated with higher
l3 We appreciate Ro Verrecchia for bringing this to our attention.

240

M.N. Durroughand NM. Stoughton,Entry andjnancial disclosure

costs. The different predictions can be traced to the ways in which competition
affects the respective cost definitions.
The detailed model of the appendix assumes a standard Coumot duopoly
structure. Although this is not the only possible duopoly solution, it is a
reasonable one in our simultaneous move game. Other models are possible,
however. For example, the firms might be engaged in Bertrand competition
(price choice). In order to deter ent_ry, the incumbent could choose a low price.
In the simultaneous setting, however, there is no way that the incumbent can
signal their intention of flooding the market (unless this is incorporated in the
disclosure mechanism as a policy choice); moreover this threat may not be
even credible (not subgame perfect). Alternatively, the incumbent could attempt to be a Stackelberg leader. The incumbents profit as a duopolist would
then be higher than as a Coumot duopolist. The level of profits is affected, but
the analysis of equilibrium would not be. The incentive for deterrence is
lessened. but the basic tradeoffs are still the same.
Appendix
A. I. A Cournot duopoiy game with diferentiated

products

For illustration, we work out the comparative statics in the case of a

Cournot game with linear demand and cost. Assume that the incumbent is
faced with an inverse demand function for its product of the form:
Pi=a-b(Qi+tQi),

08)

where Pi, i = Z, E, are the prices; Qi and Qj, j = E, I, are the quantities sold;
and 0 I t I 1 is the coefficient of differentiation. If t = 1, then we have perfect
substitutes (homogeneous products).
Given this demand, the incumbent (variable) profit is

when the marginal cost of production, c, is assumed to be constant. If the

incumbent remains as a monopolist, then its profit-maximizing output is
monopoly profit is 17, =
Q,,, = (a - cM2b). l4 The corresponding
(a - c)*/(4b).

As long as a > c, the output and profit are strictly positive, thereby creating
an inducement for entry by the potential entrant. If entry does take place, then
14Based on a simple behavioral assumption that the monopolist chooses the quantity (price)
that maximizes his profit, taking QE = 0. This behavior may not be optimal if the order of moves
is reversed and the entry decision is made subsequent to quantity setting. For example, limit
pricing models examine the incentive of the monopolist incentive to cut price to discourage entry.

M, N. Durrough and N. M. Stoughton, Entry and financial

the market is shared. In the case of a Cournot-Nash

equilibrium outputs are

Q,=

2(u - c) - t(a - CE)

b(4-

241

disclosure

duopoly game, the

and QE=2b-+t(4
b(4-t2)

t2)

where cE is the entrants marginal cost. For the outputs to be strictly positive,
we assume that 2( a - c) - t( u - cE) > 0 and 2( a - cE) - t( a - c) > 0. Special
cases of interest would be: (1) when c = cE and (2) when c = ?, and t = 1.
Then, Q, = QE = (a - c)/b(2 + t) and Q, = QE = (a - c)/3b, respectively.
Substituting optimum quantities to derive the equilibrium prices allows us
to calculate Coumot equilibrium (variable) profits for the two firms (before
any fixed cost or cost of entry):
~

&J-c)-r(a-c,)j2

09)

b(4 - t)
and
II

=
E

{2(-,)-~b-c)j2
b(4-t2)2

To see how the entry incentive of the potential entrant is affected, it is useful
to examine comparative statics of the above equilibrium. For example, we
show that an increase in the value of the demand intercept will raise the
equilibrium profits of both duopolists. To see this, totally differentiate (19) and
(20) with respect to a. Using the envelope theorem,

dn, _ 2{2(a-c) 4--c,))

da

b(2 + r)(4 - P)

dn,
-=
da

2{2(u - CE) - t(u - c)}

>.

and
b(2 + t)(4 - P)

> 0.

Similarly it is straightforward to show that the slope of the demand curve

and the coefficient of differentiation affect the profits of duopolists in the same
direction. That is, the flatter the demand curve (the lower the value of b), the
higher the profits. The more differentiated the products are, the higher the
profits. This latter comparative static requires the assumption that parameter

M. N. Durrough and N. M. Stoughton, Entry and financial disclosure

242

values satisfy
a(2-t)+4ct
cE

<

4+t2

when c 5 cE.
A.2. [A21 versus [A2]
It is possible to compare the implications of the two alternative assumptions, once we have the profit levels for the incumbent and entrant as (19) and
(20). The assumption [A21 states that II,, 2 lI,, implying that the low type
monopolist has a higher profit level than the high type under duopoly. This is
a result of two factors: (1) industrial structure and (2) type difference. Given
equations for II,+, and (19) it is simple to compare various profit levels. Since
2( a - c) - t( a - cE) > 0, we can compare the profit levels by comparing
a-c

26

and

2b7-44~-C,)
(4-12)&

I.

For example, suppose a is the private information of the incumbent. Assume

a E {a, a> and a = g + A. Simple algebra shows that

This simplifies to a condition that A I (a - c)/2 when t = 1 and c = cE. The

type difference cannot be too big, given the Coumot duopoly structure. If the
firms played a different duopoly game, the bound on the type difference
changes. For example, if the incumbent is a Stackelberg leader, then its profit
in the duopoly game is higher than that under Coumot game. Therefore, the
bound on type difference would be smaller.
A similar result obtains with respect to b. Let b E { _b,b} and 6 = hfi.
.-.
Then:

&,>?1,

(fl- ?)(a
hs

c)

4(a-c)-2t(a-c,)

If c = cE and t = 1, then this simplifies to h 5 :.

The situation is different for t, however. Since the best possible parameter
value is t = 0 (total independence), for any value t > 0, the duopolists have to

M. N. Out-rough and N. M. Stoughton, En@ andjinancial

disclosure

243

share the market. Profit is strictly lower for the duopolist incumbent regardless
of demand or cost conditions as long as t > 0. Therefore, [A21 holds strictly in
this case.
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