Transaction Costs and Competition among Audit Firms in Local Markets

We develop a measure to capture an audit firm's competitive position in a local audit market based on the transaction costs of changing audit firms included in DeAngelo's (1981) multi-period audit pricing model. Our competition measure reflects the size difference between the largest audit firm in a market and the other audit firms operating in that market. We find that audit fees of client firm i decrease as this size difference increases. This result suggests that dominant audit firms charge higher audit fees because of their significant local competitive advantage over smaller audit firms. In addition, we show that the boundaries of audit markets are mainly specified by client industry at the city level. However, the size of operations of a dominant audit firm outside such markets can enhance its competitive advantage within a client-industry, city-level market. Our study provides a market-power-based explanation for the excess audit fees earned by the largest audit firm(s) in local audit markets and advances understanding of audit market competition