This paper develops a simple, two‐period specialization model to analyze the effect of start‐up costs on auditing competition. Audit firms in the model make strategic specialization and pricing decisions. Through specialization, an audit firm achieves a comparative cost advantage over its competitors for all clients whose characteristics are closer to its area of specialization. This comparative cost advantage is further fortified by the presence of start‐up costs. As a result, each audit firm obtains some market power and is able to price‐discriminate across clients by offering “specialization‐and‐relationship‐specific” audit fee schedules. This paper demonstrates that the practice of “low‐balling” is a natural consequence of competition among audit firms. However, low‐balling occurs only in a certain market segment where audit firms compete fiercely. This paper also shows that a policy of banning low‐balling acts as a substitute for the commitment of the audit firms to partially collude their pricing policies and results in increased profits for audit firms and increased fees. However, it also results in audit firms choosing specializations in a more efficient way, thereby reducing total auditing costs.

Major accounting firms in the United States have singled out elimination of joint and several liability as one of the most needed legal reforms in the country. The recent legislation of the Private Securities Litigation Reform Act of 1995 replaced joint and several liability with proportionate liability. This paper develops a simple model to analyze the economic consequences of such a change in the legal environment facing public accountants. In particular, we examine the incentive effects induced by the proportionate liability rule on the auditor's effort and financial statement users' litigation decisions. Our analysis demonstrates that replacing joint and several liability with proportionate liability can decrease the equilibrium audit effort, lawsuit probability, market price of the firm, and audit fee. More important, even though the proportionate liability rule reduces the equilibrium audit effort, we show that it can actually increase social welfare.