The Paradox of Optimal Disciplining: Better Governance May Lead to Greater Fraud

Abstract

This paper proposes an analysis of the effectiveness of monitoring and sanctions applied by a transfer-maker when this external discipline is combined with the internal discipline of the transfer-receiver. Besides the fact that costs of monitoring and punishment are explicitly taken into account, an original feature of our model is that internal and external disciplines are made comparable: the two types can be summed up to obtain an aggregate discipline. We show that, paradoxically, an (exogenous) improvement of internal discipline may be over-compensated by the transfer-maker so that total discipline actually decreases and the incidence of fraudulent behaviour increases. The relationship between internal and total disciplines may thus be non-monotonous. Fraud may increase despite an improvement of the internal discipline as cost savings are optimally implemented.