The Effects of Audit-Firm Monopolies within Local Audit Markets

Abstract

This study examines auditors who monopolize audit markets (monopolist auditors), defined as a particular industry within a city (Numan and Willekens 2012), and their pricing strategy as well as audit quality. I document that monopolist auditors charge lower fees than industry specialist auditors, suggesting that monopolist auditors discount audit fees to deter new entrants. This result is consistent with monopolists using a limit pricing strategy (Milgrom and Roberts 1982) but contrasts with regulators’ concerns about monopoly pricing. I also find that the monopolist auditors more frequently fail to detect misstatements than industry specialist auditors that do not have monopolies. This is consistent with regulators’ concerns about market-dominating auditors’ complacency (GAO 2003, 2008). In cross-sectional tests, I document that the limit pricing is predominantly evident among clients in homogenous operation industries, where the monopolist auditors would fear more for new entrants because the monopolist auditors would forgo more profits generated from clients in homogeneous operation industries. On the other hand, I find that the limit pricing is less evident among clients in industries requiring complex accounting where the monopolist auditors would have less fear for new entrants because barriers to entry are high in industries with complex accounting. Finally, I find that monopolist auditors’ audit failures are more pronounced when market competition within a city is low, where the monopolist auditors would have even lower incentives to improve audit quality.