Allocating Monitoring Effort

Abstract

In many situations, one party can monitor a second party and chooses how much monitoring to do. However, in many of these situations, monitoring by other parties can (imperfectly) substitute for monitoring by the first party. As a result, the first party may attempt to "free ride" on the monitoring efforts of others. We examine how the ability to substitute monitoring by third parties affects the amount and allocation of monitoring activities. In both the case when monitoring activities are perfect substitutes and when they are imperfect substitutes, we find that too little monitoring is done and there is a misallocation of the monitoring burden. One implication of our analysis is that to achieve Pareto improvements in monitoring, either the first party's benefits must be enhanced or its costs subsidized. Another implication is that analyses that study one particular monitoring mechanism without including the effects of substitution may be incomplete.

JEL Classification: L51, D62