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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 specified by client industry at the city level and the other audit firms operating in that market. We find that audit fees of a client decrease as this size difference increases. This result suggests that smaller audit firms charge lower audit fees because of their competitive disadvantage to the local largest firm.
Based on a theory of transaction costs associated with audit firm change, we hypothesize and find that audit fees decrease as the size difference between the dominant audit firm in a market and an incumbent audit firm increases. We develop a measure of audit firms’ competitive positions, termed DIFFERENCE, which is the size difference between the largest auditor’s operations in a market and the size of an incumbent audit firm’s operations. We show that DIFFERENCE can consistently capture audit-firm-specific competition in the market, better than NW’s DISTANCE measure. We also investigate the boundaries of local audit markets and find evidence that competition occurs mainly at the MSA-Industry level, rather than at the MSA level. However, the dominant firm’s competitive position in an MSA-Industry market is strengthened by the size of its operations outside the MSA-Industry market. Our analyses suggest that variations in the transaction costs of changing audit firms for the clients of incumbent audit firms are an important, hitherto undocumented determinant of the pricing of audit services. This is not too surprising since these transaction costs of changing auditors are an important element of DeAngelo’s (1981) multi-period audit pricing model. While the implications of that model have been used to investigate the phenomenon of “lowball” pricing in the first (early) period(s) of an audit engagement, to our knowledge, no one has investigated the implications of the model for the pricing of continuing audit engagements where the level of transaction costs determines the level of quasi-rents (and perhaps monopoly rents) an auditor can incorporate into audit fees.