| Summary: | This dissertation develops variants of the well-known Hotelling’s location model to examine the nature of competition in the audit market where audit firms make strategic specialization and pricing decisions.
In a multi-period spatial oligopoly model of auditing competition, audit firms obtain
market power through their service specialization with respect to client characteristics relevant to audit production. This market power allows audit firms to price discriminate among
clients. Competition among audit firms is localized: an audit firm optimally charges a client,
to whom it has the lowest auditing cost to serve, the marginal auditing cost of the second
lowest-cost audit firm. These equilibrium audit firms’ pricing strategies result in an allocation of clients’ surplus and audit firms’ profits that lies in the core of the economy. The
existence of a specialization-pricing equilibrium is also established. In equilibrium, given its
rivals’ specializations, each audit firm’s profit is maximized by choosing a specialization that
maximizes the social welfare (the sum of clients’ surplus and audit firms’ profits). Moreover,
audit firms never choose the same specialization in equilibrium. Instead, in order to earn
rents as ‘local monopolists’, audit firms differentiate themselves from each other. This result
is consistent with a widely held notion that audit firms search for ‘niche’ markets, such as
industry specialization, to increase their profits.
The dissertation then focuses on a two-period spatial duopoly model in which the market
power created by audit firm specialization is now further fortified by the presence of auditors’
learning and clients’ switching costs. In this case, audit firms optimally price discriminate
among clients by offering them ‘specialization-and-relationship-specific’ audit fee schedules.
The practice of ‘low-balling’ is found to be a natural consequence of the competition among
audit firms. However, low-balling occurs only in a certain market segment where audit
firms compete quite fiercely. The analysis also demonstrates how equilibrium audit fee
schedules, audit firms’ specializations and profits, clients’ surplus, and social welfare depend
on the auditing costs, the learning rate, and the switching costs. Some interesting policy
implications are illustrated. Finally, the model is used to analyze the impact of banning
audit firms from the practice of low-balling. It is demonstrated that even though a policy of
banning low-balling always reduces competition, it improves social efficiency in some cases. === Business, Sauder School of === Accounting, Division of === Graduate
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