The Presence and Effect of the Winner's Curse in the Market for Audit Services: An Experimental Market Examination

Abstract

We argue that the market for audit services closely resembles a common value procurement (seller’s) auction, where auditors generate a private estimate of the actual cost of an audit engagement prior to quoting the client a price. Thus, we conduct a systematic examination of audit pricing and audit quality in this market setting using two experiments. In experiment one, we examine a simplified setting in which auditors determine only audit price to investigate whether the “winner’s curse” found to be pervasive in the buyer’s version of the common value auction is also present in the seller’s version. In experiment two, we examine an enriched setting in which auditors determine both audit price and audit effort to investigate the robustness of our results and the effect of the winner’s curse on audit quality. In both experiments, we find that auditors fall prey to the winner’s curse and offer low ball prices on average. But we also find a differential learning process across the two markets. In experiment one, auditors learn to reduce their low ball pricing with market experience. In experiment two, however, auditors do not reduce their low ball pricing but instead reduce their audit effort when they contract at a low ball price. Our evidence suggests that low ball audit pricing arises due to the winner’s curse, and this source of low ball pricing poses a threat to audit quality.