Abstract Past laboratory market research exploring the demand for auditing has generally assumed an exogenous audit function, where reliable investigations can be obtained for a fee. This study advances the structure of these settings by incorporating human, strategic auditors. Laboratory markets were conducted where the profits earned by buyers were conditional upon the reports of sellers. Buyers were able to investigate these reports by purchasing audit services from a third group of subjects. However, auditors made private investigation decisions in certain markets, and thus were themselves subject to risks of moral hazard. Findings indicated that despite the complexity of the setting with its multiple sources of moral hazard, both sellers and auditors expended the cost of diligent effort most of the time. There was evidence of significant associations between actions taken and negotiated prices, indicating the presence of multiperiod reputations. However, the highest prices paid to auditors and the lowest frequencies of seller misrepresentations occurred in the control markets without auditor moral hazard.
Steven J. Kachelmeier (Sat,) studied this question.