Costly Inspection and Money Burning in Internal Capital Markets

Bureaucracy and influence activities consume a great deal of managers’ time and effort in an organization. These activities are surplus destroying in the sense that they produce no direct output or information. This paper suggests a positive role for these activities. We develop a model for allocation in internal capital markets that takes a mechanism design perspective and incorporates both costly inspection and money burning (e.g. bureaucracy; influence activities) as tools for the headquarters to pursue optimal allocations. We find that the optimal mechanism deploys both the instruments of costly inspection and money burning; often at the same time on an agent.