Multimarket Contact and Mutual Forbearance in Audit Markets

Abstract

In this paper we argue that audit firms rationally consider the potential reactions of their rivals when deciding how fiercely to compete in a given market. Based on prior literature in the field of industrial organization (Bernheim and Whinston [1990]), we hypothesize that competing with the same audit firms across different industries within a geographical region (which we label “multi-industry contact”) leads to less (price) competition overall, which suggests mutual forbearance among rivals. As we characterize the audit market as a differentiated Bertrand oligopoly, pricing is a main strategic choice variable for audit firms. We predict and test whether the extent of multi-industry contact is positively associated with audit fees including several tight fixed effects specifications to rule out potential confounds. Based on a sample of 19,641 observations from 2004-2012, we find that the extent of multi-industry contact between audit firms is positively associated with audit fees controlling for inter-year, inter-industry, inter-geographical area, inter-client and inter-market segment heterogeneities. This evidence is consistent with mutual forbearance between audit firms. In supplementary tests, we find that the likelihood of client switching is negatively associated with multi-industry contact.