Which of these strategies maximizes social welfare? The answer depends on two factors: (i) the magnitude of the rents R from consulting and (ii) the marginal efficiency of enforcement。 Indeed, an increase in R has two conflicting effects: an increase in the potential for collusion between manager and auditor, and an efficiency gain from auditors’ economies of scope。

If the marginal efficiency of enforcement is sufficiently high ( e '(q*) C '(q*) ), the negative effect of an increase in R is dampened by the law, so that the positive effect from the efficiency gain dominates。 But this holds only for relatively low values of R: once the rents from consulting that can be used to bribe consultants become too high, the negative effect dominates anyway。 This is

illustrated in the top panel of Figure 2。 The solid curve represents the welfare level that obtains

when  the  regulator  allows  the  joint  provision  of  auditing  and  consulting  services,

Wˆ   (qc ; R) ,

whereas the flat line indicates the welfare level associated with the prohibition of bundling, that is, the second-best welfare level W sb (q*) 。 Below the threshold R˜ , the solid curve lies above the flat line, so that it is optimal to allow the joint provision of auditing and consulting services。 Above this

threshold, instead, it is optimal to forbid bundling。

As illustrated in the bottom panel of Figure 2, the audit standard starts off from the second-best

level

q* when

R 0 , decreases as R increases (as shown by Proposition 3) up to the threshold  R˜      ,

and reverts to the second-best   level

q*  for larger R。 Intuitively, in the region where bundling is

allowed, the standards must be gradually mellowed as R increases in order to accommodate the increasing severity of the conflict of interest。 This process stop as soon as the economy enters the region where it is optimal to forbid bundling, thereby removing the conflict of interest at its root。

But also another case is possible: if the marginal efficiency of enforcement is sufficiently low ( e '(q*) C '(q*) ), then the curve may lie entirely below the flat line, as illustrated by the dashed curve in the top panel of Figure 2。 In this case, the welfare level associated with the joint provision of auditing and consulting services, Wˆ    (qc ; R) , is always below that associated with the prohibition

of bundling, W sb (q*) , so that bundling should always be forbidden and  the audit standard  should

be set at its second-best level q* for any R。 In this case, the legal system is so inefficient that even a very small bribe to the auditor is too costly to deter。20

20  In the proof of Proposition 4 we also show that in the borderline case where

e '(q*) C '(q*) , social

welfare is the same in the two regimes, so that the regulator is indifferent between allowing and forbidding bundling for any R。

These points are summarized in the following proposition:

Proposition 4 (Interdiction of bundling and audit standards)。

If

e '(q*)  C '(q*) , then there exists a threshold value  R˜ >0 such that for  R  R˜  it is optimal to

allow  bundling  of  auditing  and  consulting,  and  to  forbid  it  for   R R˜   。  The  optimal audit

standard is  qc(R)  for  R  R˜  and  q*  for  R  R˜ 。

If

e '(q*) C '(q*) , then it is optimal to forbid bundling of auditing and consulting and set the