Audit market segmentation : the impact of mid-tier audit firms on competition

Simons, Dirk ; Zein, Nicole

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URN: urn:nbn:de:bsz:180-madoc-25212
Document Type: Working paper
Year of publication: 2007
The title of a journal, publication series: None
Publication language: English
Institution: School of Law and Economics > Sonstige - Fakultät für Rechtswissenschaft und Volkswirtschaftslehre
MADOC publication series: Sonderforschungsbereich 504 > Rationalitätskonzepte, Entscheidungsverhalten und ökonomische Modellierung (Laufzeit 1997 - 2008)
Subject: 330 Economics
Classification: JEL: D43 M42 ,
Subject headings (SWD): Europäische Union , Wirtschaftsprüfung , Marktstruktur , Marktsegmentierung , Produktdifferenzierung , Wettbewerb
Abstract: It is a global phenomenon that more than 75% of a developed country's listed companies are clients of a Big-4 auditor. However, the economic consequences of this concentration are inconclusive. On the one hand, a kind of similarity'-hypothesis suggests that the existence of a few global auditors might induce Bertrand-oligopoly-like national audit market structures due to a lack of auditor differentiation in size and quality. Consequently, virtually no profits should be gained by the audit companies. On the other hand, the “too-big-to-fail”-hypothesis suggests that governmental bodies might refrain from sanctions against Big-4 auditors, because they are afraid of further consolidating an oligopolistic market structure by dissolving another major supplier. In the long run, impairing competition could result in rather high audit profits. Irrespective of which hypothesis they adhere to, regulating authorities recently recognized enabling mid-tier auditors to serve large multinational clients as a promising cure for the aforementioned problems. Accordingly, the goal of our paper is to develop a comprehensive model of audit market segmentation for analyzing the competitive impact of mid-tier auditors. As a modeling device we make use of a Hotelling setting, which has several advantages: Firstly, it depicts strategically motivated product differentiation, i.e., auditors supplying different quality levels can be analyzed. Secondly, in contrast to perfect competition models, in our model most audit firms realize non-negative profits better describing business practice. Thirdly, explicitly matching suppliers and customers allows to distinguish supply-side and demand-side audit quality. Major results of our analysis are the following: A loss in high-quality auditors' flexibility to customize their audit programs is followed by an increase of audit quality offered by mid-tier firms. But, if mid-tier firms left the audit market, the Big-4 firms would raise the offered quality level, incurring growing profits as well. Further, the “market power” hypothesis stating that greater market shares imply rising fees can be supported theoretically.
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