Anat R. Admati, Paul Pfleiderer, and Josef Zechner
Journal of Political Economy, Vol. 102, Issue 6, Pages 1097-1130
The authors develop a model in which a large investor has access to a costly monitoring technology affecting securities’ expected payoffs. Allocations of shares are determined through trading among risk-averse investors. Despite the free-rider problem associated with monitoring, risk-sharing considerations lead to equilibria in which monitoring takes place. Under certain conditions, the equilibrium allocation is Pareto efficient and all agents hold the market portfolio of risky assets independent of the specific monitoring technology. Otherwise, distortions in risk sharing may occur and monitoring activities that reduce the expected payoff on the market portfolio may be undertaken. Copyright 1994 by University of Chicago Press.