PERMANENT EFFECTS OF TEMPORARY FRAUD IN TRANSITION ECONOMIES: THE ROLE OF HONESTY, PRICE, AND LIMITED INFORMATION FLOWS

Abstract

This paper presents a simple dynamic game in which a population of "cheaters" exerts a negative reputational externality on a population of honest firms. lt is shown how this externality, coupled witli limited information flows amongst buyers, leads to there being "fraud" only in the initial stages of trade. Nevertheless, this temporary fraud can permanently prevent sorne honest sellers from trading with certain buyers. This happens exactly when, in a static setup, "honests" would not have been able to induce separation from "cheaters" by incurring initial losses. Finally, it is shown, in an elementary case, that increasing the number of honest sellers will generally increase welfare, though, in very special cases, it might not.