Auditor Size, Market Segmentation and Litigation Patterns: A Theoretical Analysis

We provide a theoretical rationale for the observed audit industry structure where well-capitalized auditors hold an extremely large market share. Our analysis focuses on the economics of trading in an adverse selection market where audit quality is unobservable. We show that concentration of market share can arise even if well-capitalized auditors have no relative advantage with regard to supplying high-quality audits, and that the strategy of attracting a narrow base of high-margin clients is typically unsustainable in rational expectations equilibrium. Other results derived from our analysis of strategic competition for clients also conform (qualitatively) with empirical findings regarding audit fee structures and litigation rates. In particular, we show that better-capitalized auditors get a dominant market share, produce more accurate reports and are more profitable. In addition, we show that the imposition of high minimum standards increases the market power of wealthy auditors, even though smaller auditors can potentially provide the same level of audit quality at lower fees. All these results are demonstrated within a framework that endogenizes both a securities trading market and profit-maximizing auditors who strategically compete for clients.