An Examination of the Impact of Audit Market Concentration on Audit Fees through the Prism of Auditors’ Efficiency

The extant auditing literature documents an inconsistent relationship between audit fees and market concentration. In this paper, we argue that the impact of market concentration on audit fees is auditor and auditee specific. Based on the fact that the audit services to an auditee are generally provided in their entirety by one auditor, we conjecture that the competition for an engagement is essentially based on costs (i.e., Bertrand competition) and that larger auditors are more efficient. Accordingly, we develop an audit fee determination framework that predicts that the disparity in sizes of the largest and the second-largest auditors result in differential audit fees charged by the largest auditor and other auditors. Since the concentration of an audit market is inherently associated with the size disparity in the market, our fee determination framework suggests that market concentration does not affect audit fees uniformly. Indeed, we document that market concentration increases the audit fees to auditees (in particular the large auditees) serviced by the largest auditor in a market and decreases the audit fees to all auditees serviced by other auditors. The results are consistent with our theory and explain the inconsistent empirical relationship between concentration and audit fees documented in the literature.