Much Ado About Nothing? Overreaction to Random Regulatory Audits

59 Pages Posted: 20 Sep 2023

See all articles by Samuel Antill

Samuel Antill

Harvard Business School

Joseph Kalmenovitz

University of Rochester - Simon Business School

Date Written: August 30, 2023

Abstract

Regulators often audit firms to detect non-compliance. Exploiting a natural experiment in the lobbying industry, we show that firms overreact to audits and this response distorts prices and reduces welfare. Each year, federal regulators audit a random sample of firm-client pairs. Following an audit, we find that audited clients are more likely to retain the audited lobbying firm, and they pay a lower price for the same amount of services. Estimating a dynamic structural model with our natural experiment, we show that this pattern is driven by overreaction: clients are almost indifferent to audits, but lobbying firms mistakenly believe their clients view audits as extremely negative events. Therefore, lobbyists offer unnecessary price discounts to retain audited clients. In a counterfactual world with no overreaction, we estimate that price corrections and better client-firm matching quality would increase welfare by 6.4%. Our results are the first to document an unintended effect of regulation on prices and matching, as regulated entities overreact to regulatory actions.

Keywords: Audit, regulation, overreaction, structural estimation

Suggested Citation

Antill, Samuel and Kalmenovitz, Joseph, Much Ado About Nothing? Overreaction to Random Regulatory Audits (August 30, 2023). Available at SSRN: https://ssrn.com/abstract=4557377 or http://dx.doi.org/10.2139/ssrn.4557377

Samuel Antill

Harvard Business School ( email )

Soldiers Field Road
Morgan 270C
Boston, MA 02163
United States

Joseph Kalmenovitz (Contact Author)

University of Rochester - Simon Business School ( email )

Rochester, NY 14627
United States

HOME PAGE: http://sites.google.com/view/jkalmenovitz

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