Much Ado About Nothing? Overreaction to Random Regulatory Audits

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.