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I've done some rigorous analysis and a bit of hex diving, and I think I've gotten a pretty good grasp on how M&M1 decides which monsters you're going to fight in a random encounter.

There are 11 tiers of monsters, plus another 19 monsters that do not exist in any tier. Refer to this list:

Each area in the game has a minimum tier and a maximum tier, from 1 to 10. In a random encounter, monsters may be selected from any tier in between these numbers, inclusive. For instance, Sorpigal has both minimum and maximum of 1, and you will only see the 16 monsters from the first tier, barring certain circumstances. Castle Alamar has a minimum of 1 and a maximum of 10, and can spawn any of the first 160 monsters in random encounters.

The 11th tier is sea encounters. As far as I can tell, any 11th tier monster may spawn on any random encounter when you are on a water tile. Monsters 177-195 only appear during fixed encounters.

Here is a pastebin of all the areas in the game, and their monster levels:

Sorry for the unreadability. But if you go to the RAW Paste Data and copy it into an Excel spreadsheet, it should be legible.

In addition to that, a few areas have more forgiving monster limits. Sorpigal has a limit of 8 monsters per encounter. Sorpigal, Sorpigal Cavern, Portsmith, and Algary have a limit of 10 monsters per encounter. All other locations have a limit of 16.

Some squares trigger random encounters which follow the monster tier rules. But some also trigger fixed encounters, which don't always follow monster tier rules. For instance, the west exit from C2 is guarded by tier 4 Caryatid Guards, even though the location has a max tier of 3. And B2, though it has a max tier of 5, has a very nasty tier 9 Lich in the southern forest.

It's also possible to temporarily raise an area's tier levels through events. For instance, if you visit the northwest corner of Sorpigal's jail, the tier levels rise from 1-1 to 3-6.

I've heard that M&M1 has scaling based on your level, but I haven't been able to verify this. I've taken a starting party to the basement of the Fabled Building of Gold and found tier 8 monsters there, and I've taken a level 25 party to D1 and found tier 2 monsters there. Maybe when the monsters are chosen, it's random but weighted more toward the upper tiers the higher level your party is, but your level doesn't seem to affect the tier limits.
Good work.

My experience is that MM1 is indeed wholly area scaled when it comes to random encounters, which I think is the optimal design for an open world CRPG. In comparison. a game like Oblivion is pointless to play unmodded, since the scaling to your level makes exploring essentially pointless.

I'd be very interested to see a similar "dissection" of MM2. It has a more complex system than MM1, with a mix of level and area scaling, and fixed encounters.
ikantspelwurdz: Maybe when the monsters are chosen, it's random but weighted more toward the upper tiers the higher level your party is, but your level doesn't seem to affect the tier limits.
This would be interesting to test.
I've also found that some squares have non-fixed encounters, but draw from a pool of enemies unrelated to the area's monster tiers. For instance, Portsmith has random encounters of monster levels 1-3. The squares on the southern edge of the map draw from these pools. But the locked doors randomly spawn hags, lesser demons, lesser devils, or caryatid guards, which are levels 2-7.
All of it is quite an interesting info.

Do you plan to do something similar with Might and Magic II?
It's possible, but don't count on it. I'm replaying M&M1 and testing my data, and finding more things that complicate it. M&M2 is probably my least favorite in the series, and analyzing an even more complicated system with even more RNG is intimidating.