Optimal Policy Response to Food Fraud

Transcription

1 Optimal Poliy Response to Foo Frau Sye Imran Ali Meerza University of Nebraska-Linoln Konstantinos Giannakas University of Nebraska-Linoln Amalia Yiannaka University of Nebraska-Linoln Selete Paper prepare for presentation at te 2018 Agriultural & Applie Eonomis Assoiation Annual Meeting, Wasington, D.C., August 5-August 7 Copyrigt 2018 by Meerza, Giannakas an Yiannaka. All rigts reserve. Reaers may make verbatim opies of tis oument for non-ommerial purposes by any means, provie tat tis opyrigt notie appears on all su opies.

2 Optimal Poliy Response to Foo Frau Abstrat Tis stuy analyzes te optimal response of te government to foo frau wile aounting for te asymmetri effets of foo frau on onsumers an prouers, te enogeneity of te prouer quality oie, an asymmetries in te probability of foo frau etetion. Wile te government an, teoretially, eter foo frau troug a signifiant inrease in te ertifiation osts an/or te monitoring-punising system, te analysis sows tat te optimal poliy response epens on te effiieny of isonest prouers, te type of foo frau, te politial objetives of te government, an te relative osts of ifferent types of enforement. In aition to aounting for te asymmetri effets of foo frau, te expliit onsieration of agent eterogeneity an te enogeneity of te prouer quality enables us to sow tat, ontrary to wat is traitionally beleive, te effet of enforement on te purity of labeling an te average prout quality epens on te effiieny of isonest prouers. Intriguingly, wen te publi law enforement ageny offiials engage in bribery, te monitoring an punisment system witout aressing orruption oes not erease te frauulent beavior but, instea, inreases te inentives to ommit frau. Keywors: optimal poliy response, foo frau, eterogeneity 1. Introution Wile foo frau is as ol as ommere itself, its intensity an frequeny ave been on te rise in reent years ue to te growing omplexity of te multi-tiere agri-foo system an te inrease iffiulty in eteting frauulent beavior. For instane, te total number of onfirme foo aulteration inients in te two years from 2011 an 2012 was 60 perent iger tan tose between 1980 an 2010 (USP 2013). Similarly, te National Auit Offie of te Unite Kingom (UK) reveale tat te onfirme foo frau inients in te UK were 67 perent iger in 2012 tan tose in 2009 (Avery 2014). Wile te atual ost of foo frau is unknown 1

3 sine te objetive of foo frau for eonomi gain is not to be etete; (Jonson 2014), te PwC Networ (2015) estimates tat foo frau may ost te global foo inustry between $30 billion to $40 billion per year. Te ost of foo frau to te UK foo an rink inustry ave been extimate up to 11.2 billion (equivalent to $15.23 billion) per year (Gee et al. 2014). Foo frau an be efine as te eliberate substitution, aition, tampering, or misrepresentation of foo for eonomi gains (Spink an Moyer 2011). In tis ontext, foo frau an be ivie into two broa ategories: foo aulteration an mislabeling. Wile foo aulteration an be efine as te intentional substitution or aition of substanes in foo prout to reue te proution ost or inrease te value of te prout, mislabeling refers to ats of misrepresenting te foo prout. Foo frau is motivate by eonomi gains an is enable by te fat tat te information about te nature of reene goos is normally asymmetri. Wile ertifiation an labeling resolve te information problem fae by onsumers, imperfet enforement of labeling/ertifiation requirements reates opportunities for prouers to mislabel or aulterate foo prouts. In reent years, foo frau sanals like te Cinese milk an European orsemeat sanals, ave apture te attention of te meia, onsumers, an governments aroun te worl an ave raise serious onerns about foo safety (Lotta an Bogue 2015). Foo frau as been reognize as an important an allenging issue treatening global foo safety an seurity. Bot te Congressional Resear Servie (CRS) an Governmental Aountability Offie (GAO) of te Unite States ave publise several reports on foo frau. Tese reports aress te foo frau onerns an igligt past an ongoing feeral an ongressional ations to strengten te ampaign against foo frau (CRS 2014 an GAO 2011). Similarly, te European Commission (EC) onsiers foo frau as one of te top five allenges for te overall 2

4 European eonomy (Anklam 2014). After te orsemeat sanal in Europe, te European Union (EU) aknowlege tat, wile foo frau is not a novel penomenon, ombatting foo frau is a relatively new issue on te European agena, an tat in te past it as never been a key priority for legislation an enforement at EU or national level (European Parliament Report 2013). Reently, te European Parliament as aopte new regulatory measures to ombat foo frau aross te EU. Speifially, it as introue along wit signifiant requirements for foo traeability, strit enforement measures wit strit penalties for frauulent beavior (Putinja 2017) 1. Similarly, te Canaian Foo Inspetion Ageny (CFIA) as, istorially, not punise to te full extent frauulent beavior but trie, instea, to elp tose foo businesses get bak into ompliane. However, sine te mistrust in te veraity of labeling an autentiity of foo prouts as been on te rise in reent years, CFIA is taking a strit an punitive approa for bot mislabeling an foo aulteration (Jameson an Paine 2016). 2 Combating foo frau as also beome a key priority of te Cinese government after te milk sanal tat amage te reputation of Cina s foo exports an was a big blow to te booming Cinese airy inustry (Huang 2014). In 2011, te Supreme People s Court of Cina eree tat onvite suspets in letal ases of foo frau (i.e., ases in wi people ie ue to foo aulteration) woul be given te eat penalty, wile onvite suspets in non-letal ases of foo frau, su as mislabeling, woul fae extene imprisonment an inrease fines (Danovi 2015). 3 Wit many ountries aopting ifferent measures to strengten te regulatory apaity to ombat foo frau, te question tat naturally arises is wat is te optimal poliy response to foo frau. Despite te inrease prevalene of foo frau aroun te worl, bot te teoretial an te empirial guiane on wi enforement poliy works best to ombat foo frau are 3

5 virtually absent. Exeptions are te stuies by Hamilton an Zilberman (2006), Baksi an Bose (2007), an Spink et al. (2016). Hamilton an Zilberman (2006) stuy te performane of an eo-ertifiation poliy in te presene of mislabeling. Tey fin tat te performane of te eo-ertifiation poliies epens on market struture. Tey also sow tat te average quality of te green prout an be inrease by imposing a positive per-unit ertifiation ost. Baksi an Bose (2007) stuy te performane of labeling requirements bot in te form of self-labeling an tir-party labeling wile assuming te former is ostless an te latter requires a per unit fee. Tey fin tat wile, in most ases, self-labeling is te soially optimal option, te tir-party labeling beomes soially optimal wen te per-unit monitoring ost is ig an/or wen te total number of firms to be monitore is low. Spink et al. (2016) argue tat it is effetive to fous on reuing te net expete benefit of frauulent beavior rater tan on te riminals sine tere are ifferent types of frau an isonest prouers. In oter wors, te government soul fous on key rime prevention-base approa to reue te opportunity or motivation to ommit frau. 4 Tey also argue tat several regulations an initiatives often fous only on te ealt azars of foo frau instea of all eonomi onsequenes, e-empasizing te eonomi impats of foo frau sanals. Wile reviewing te teoretial literature on te eonomis of labeling, Bonroy an Constantatos (2014) also ientify an explain te auses of unesirable sie-effets of labeling, su as mislabeling. Regaring te enforement poliy to ombat mislabeling, tey argue tat any given purity level of labeling in te ig-quality market an be aieve troug eiter imposing a positive per-unit ertifiation ost or introuing a monitoring-punising system. 4

6 Wile te aforementione stuies fous on te performane of ifferent types of ertifiation in te presene of mislabeling, tis stuy evelops a teoretial moel to etermine te optimal regulatory response to foo frau bot in te form of foo aulteration an mislabeling. Key ifferentiating attributes of our approa (an ontributions of tis stuy) are tat it expliitly aounts for (1) eterogeneous onsumers an prouers (i.e., onsumers iffering in teir preferenes an prouers iffering in teir proutive effiieny), (2) te enogeneity of te prouer quality oie, an (3) asymmetries in te probability of te foo frau etetion. Te rest of te paper is organize as follows. Te next setion presents a moel of eterogeneous onsumers an prouers an imperfetly ompetitive foo ompanies an etermines te market an welfare effets of relevant market agents involve wen tere is no frau in te market. Te following setion fouses on onsumer an prouer eisions in te presene of foo frau bot in te form of foo aulteration an mislabeling. Setion 4 etermines te optimal poliy response of te government to foo frau. Setion 5 summarizes an onlues tis paper. 2. Benmark Case: No Foo Frau 2.1 Consumer Problem Consier vertial prout ifferentiation moel were a onsumer onsumes one unit of eiter ig-quality (), low-quality (l) or substitute prout (e.g., organi apple, onventional apple or orange). Assuming tat te unit onsumption represents a small sare of total inome, te onsumer utility funtion an be written as: (1) U = U P + λ α, if a unit of te ig-quality prout is onsume U l = U P l + λ l α, if a unit of te low-quality prout is onsume 5

7 U a = U, if a unit of te substitute prout is onsume were U is a base level of utility erive from te onsumption of a prout. Te terms U, U l an U a present te utility assoiate wit te unit onsumption of ig-quality, low-quality an substitute prouts, respetively. To simplify te analysis, U a represents a reservation level of utility wi is equal to te base level of utility U. Te parameters P an P l are te pries of te ig an low-quality prouts, respetively, wile λ an λ l are non-negative utility enanement fators assoiate wit te onsumption of ig an low-quality prouts, respetively. Te arateristi α aptures te eterogeneity in onsumer preferenes for te ig an low-quality prouts. For simpliity an traeability, tis stuy assumes tat αε[0,1] an onsumers are uniformly istribute between te polar values of α. Moreover, to allow for positive market sares of all vertially ifferentiate foo prouts, we assume tat P > P l an tat te valuation of te quality ifferene between te ig an low-quality prouts exees te ig-quality prie premium for all onsumers (i.e., λ λ l > P P l ). Te onsumer purasing eision is etermine by te utilities erive from onsuming te ifferent foo prouts. In tis ontext, te onsumer wit ifferentiating attribute α l : U =U l is inifferent between onsuming a unit of ig-quality prout an a unit of low-quality prout, wile te onsumer wit ifferentiating attribute α l : U l =U a is inifferent between te low-quality prout an te substitute prout. Consumers wit ifferentiating attribute αε[0, α a ), αε(α a, α l ), an (α l, 1] prefer te substitute prout, te low-quality prout, an te ig-quality prout, respetively (see figure 1). Normalizing te mass of onsumers to unity, α a α l an 1 α l provie te onsumer emans for te low-quality prout an te igquality prout, respetively, as: (2) x l = α l = λ lp λ P l λ l (λ λ l ) 6

8 (3) x = 1 α l = (λ λ l ) (P P l ) (λ λ l ) Te total welfare of onsumers is given by te area uner te effetive utility urve (i.e., te ase kinke line) in figure 1 an equals: (4) TCS = CS a + CS l + CS = U a α + U l α + U α 2.2 Prouer Problem α a 0 α l α a Consier now a prouer wo proues one unit of eiter ig-quality (), low-quality (l) or alternative prout. Te prouer proution eision is etermine by omparing te net returns assoiate wit te proution of ifferent foo prouts. Let A enote te eterogeneity in prouer effiieny an prouers be uniformly istribute between te polar values of A (i.e., Aε[0,1]). A prouer wit attribute A as te following net returns funtion: (5) π = P f w δa if a unit of te ig-quality prout is proue π l = P l f w l γa π a = 0 α l if a unit of te low-quality prout is proue if a unit of an alternative prout is proue were π, π l, an π a are te net returns assoiate wit unit proution of ig-quality prout, low-quality prout, an alternative prout, respetively. Te parameters P f an P l f are te prouer prie for ig-quality prout an low-quality prout, respetively; w an w l are te proution osts of ig-quality prout an low-quality prout, respetively, wi are outsie te ontrol of prouers; an δ an γ are te ost enanement fators assoiate wit te proution of te ig-quality prout an te low-quality prout, respetively. 5 Te ig-quality prout reeives a prie premium, but it is more expensive to proue tan te low-quality prout (i.e., i.e., P f > P l f an w > w l ). To allow positive supply of all prouts in te market, it is assume tat (P f w ) > (P l f w l ). In tis ontext, te prouer 1 7

9 wit ifferentiating attribute A : π =π l is inifferent between prouing a unit of ig-quality prout an a unit of low-quality prout, wile te prouer wit ifferentiating attribute A l : π l =π a is inifferent between te low-quality prout an te alternative prout. Prouers wit ifferentiating attribute Aε[0, A ), Aε(A, A l ), an (A l, 1] fin it optimal to proue te ig-quality prout, te low-quality prout, an te alternative prout, respetively (see figure 2). Normalizing te mass of prouers to unity, A an A l A provie te supplies of te ig-quality prout an te low-quality prout, respetively, as: (6) x = A = (P f P f l ) + (w l w ) (δ γ) (7) x l = A l A = δ(p f l w l ) γ(p f w ) γ(δ γ) 2.3 Equilibrium Conitions Tis setion etermines te market outomes of te benmark moel. In tis stuy, it is assume tat milemen ave market power bot wen buying te foo prout from prouers an wen selling te proesse foo prout to onsumers. Te milemen fae te eman an supply urves wi are erive in equations (2), (3), (6), an (7). Figure 3 presents te equilibrium onitions in te markets for te ig an low-quality prouts wen tere is no frau. Te parameters θ i an θ f i (i =, l) are onjetural variation elastiities wi apture te egree of market power of milemen wen selling te proesse foo prout to onsumers an buying te foo prout from prouers, respetively. Te profit maximizing milemen proue te quantity etermine by te equality of te relevant marginal revenue an marginal outlay seules. One te optimal quantity is etermine, te profit maximizing milemen arge te maximum prie onsumers are willing to pay for tis quantity an offer te minimum prie tat will inue prouers to supply of neessary quantity of te foo prout. 8

10 3. Foo Frau 3.1 Foo Aulteration Foo aulteration an be efine as ats of orrupting, ebasing or making a foo prout impure by aing inferior elements. Te main objetive of foo aulteration is to reue te ost of proution at te expense of onsumer ealt (Sobani 2015). In oter wors, to inrease te profit margin, isonest prouers use ifferent aulteration metos to reue te ost of proution, an ten market te aulterate prout as te ig-quality prout Consumer Problem In te presene of foo aulteration, tere are two types of prout in te market, i.e., te prout markete as ig-quality an te low-quality prout. However, te prout markete as igquality, in te presene of foo aulteration, inlues bot trutfully labele ig-quality an aulterate prout. It soul be note tat, in tis stuy, te ig-quality prout refers te trutfully labele ig-quality prout wile te prout markete as ig-quality inlues bot te trutfully labele ig-quality an aulterate prouts. In te presene of foo aulteration, onsumers assign a probability for te presene of aulterate prout in te market an a probability of a ealt azar from onsuming an aulterate prout, reuing te willingness to pay for prout markete as ig-quality. Terefore, te utility erive from te onsumption of te prout markete as te ig-quality is given by: (8) U, = μ(u P, were U P, an U P, + λ α) + (1 μ)(u P, εψ) = U P, + μλ α (1 μ)εψ + λ α is te utility assoiate wit te onsumption of te ig-quality prout εψ is te utility assoiate wit te onsumption of te aulterate prout. Te parameters μ an (1 μ) are te probability tat te foo prouts are ig-quality prout an 9

11 aulterate prout, respetively, te term ε is te probability of getting sik wen onsuming te aulterate prout; an te parameter ψ is te total ost of reeiving meial treatment. 6 In tis ontext, te onsumer utility funtion in te presene of foo aulteration an be written as: (9) U, = U P, + μλ α (1 μ)εψ if a unit of te prout markete as ig-quality is onsume U l, = U P l, + λ l α if a unit of te low-quality prout is onsume U a, = U if a unit of te substitute prout is onsume were U,, U l,, an U a, are te utilities assoiate wit te unit onsumption of ig-quality prout, low-quality prout, an te substitute prout in te presene of foo aulteration, respetively. All oter variables are as previously efine. Following te proess evelope earlier, we an erive te onsumer emans for te low-quality an te ig-quality prouts in te presene of foo aulteration as: (10) x l, = α l, α a, = λ lp, (11) x, = 1 α l, = (μλ λ l ) (P, μλ P l, + λ l (1 μ)εψ λ l (μλ λ l ) P l, ) (1 μ)εψ (μλ λ l ) Prouer Problem In te presene of foo aulteration, a prouer an proue one unit of eiter ig-quality (), aulterate (), low-quality (l) or alternate prout. Te prouer proution eision is etermine by omparing te net returns assoiate wit te proution of ifferent foo prouts. A prouer wit ifferentiating attribute A as te following net returns funtion in te presene of foo aulteration: (12) π, = P, w δa if a unit of te ig-quality prout is proue π, = P, β(w + δa) φ(a)ρ if a unit of te aulterate prout is proue π l, = P f l, w l γa if a unit of te low-quality prout is proue π a, = 0 if a unit of an alternative prout is proue 10

12 were π, is te net returns assoiate wit te proution of te aulterate prout. Te term β(w + δa) presents te ost of prouing an aulterate prout (were 0 < β < 1) wi aptures te iea of ost savings by using te aulteration meto; an te parameters φ an ρ are te probability of frauulent beavior being etete an te penalty for etete frauulent beavior, respetively. 7 Moreover, te probability of etetion takes values between zero to one, an it is assume to be a linear funtion of te effiieny of prouers, i.e., φ(a) = φ 0 + φ 1 A. Te terms φ 0 an φ 1 present te probability tat prouers will be etete by tir parties (e.g., meia an former employees et.) an te auit probability, respetively. All oter variables are as previously efine. In te presene of foo aulteration, a prouer wit ifferentiating attribute A will proue aulterate prout wen te gains from frauulent beavior (i.e., {(w βw ) + (δ βδ)a}) exee te expete penalty (i.e., {(φ 0 + φ 1 A)ρ}). Depening on te nature of relationsip between te net expete benefit of frauulent beavior an te expete penalty, we an ientify following four senarios: (1) te net expete benefit of frauulent beavior inreases wit te effiieny of prouers (i.e., w > (βw + φ 0 ρ) an δa < (βδ + φ 1 ρ)a); (2) te net expete benefit of frauulent beavior ereases wit te effiieny of prouers (i.e., w < (βw + φ 0 ρ) an δa > (βδ + φ 1 ρ)a); (3) te net expete benefit of frauulent beavior is always positive regarless of te effiieny of prouers (i.e., w (βw + φ 0 ρ) an δa (βδ + φ 1 ρ)a; an (4) te net expete benefit of frauulent beavior is always negative regarless of te effiieny of prouers (i.e., w (βw + φ 0 ρ) an δa (βδ + φ 1 ρ)a). However, in tis stuy, we onsier only senarios 1 an 2 beause of te o-existene of all prouts in te market. Te senarios 3 an 4 are exterior solutions; i.e., non-oexistene of te ig-quality an te aulterate prouts. 11

13 Senario 1 Following te proess evelope earlier, in te presene of foo aulteration senario 1, we an erive te supplies of te ig-quality prout, te aulterate prout, an te low-quality prout, respetively, as: tl (13) x, (14) x, = A, A, = A, = {(βδ + φ 1ρ) δ}(p f, P f l, + w l ) {(βγ + φ 1 ρ) γ}w + (δ γ)φ 0 ρ (δ γ){(βδ + φ 1 ρ) δ} = w βw φ 0 ρ {(βδ + φ 1 ρ) δ} (15) x l, = A l, A, = δ(p f l, Senario 2 w l ) γ(p f, w ) γ(δ γ) Te supplies of te ig-quality prout, te aulterate prout, an te low-quality prout are given as: (16) tl x, tl = A, = {(βw + φ 0 ρ) w } {δ (βδ + φ 1 ρ)} (17) x t, = A, A, = {δ (βδ + φ 1ρ)}[P f, (βw + φ 0 ρ) P f l, + w l ] {(βδ + φ 1 ρ) γ}[(βw + φ 0 ρ) w ] {(βδ + φ 1 ρ) γ}{δ (βδ + φ 1 ρ)} (18) x l, = A l, A, = (βδ + φ 1ρ)(P f l, w l ) γ{p f, (βw + φ 0 ρ)} γ{(βδ + φ 1 ρ) γ} System-wie effets of foo aulteration Tis setion etermines te market an welfare effets of foo aulteration an ten, ompares tese effets wit tat of te benmark moel (i.e. no foo frau). Equilibrium onitions Figure 4 epits te equilibrium onitions uner foo aulteration senario 1. As mentione earlier, in te presene of foo aulteration, onsumers erease teir willingness to pay for ig-quality prout wi, in turn, reues te eman for ig-quality prout. Terefore, in 12

14 te presene of foo aulteration, te eman urve for ig-quality prout sifts to te left (from D to D, ). Sine, uner senario 1, only (some) ig-quality prouers fin it optimal to proue aulterate prout an sell it as te ig-quality prout, te supply urve of te prout markete as ig-quality oes not sift; owever, it is kinke supply urve (S ; inlues supply of bot te ig-quality an te aulterate prouts). Comparing te equilibrium quantity, onsumer prie, an prie reeive by prouers of te prout markete as igquality in te absene an presene of foo aulteration, figure 1 panel A sows tat bot equilibrium quantity an pries erease in te presene of foo aulteration. In ontrast, te eman for low-quality prout inrease (sifts from D l to D l, ) in te presene of foo frau, resulting inrease equilibrium quantity (x l, ), onsumer prie (P l, ) an prie reeive by prouers (P l, f ) of te low-quality prout (see figure 4 panel B). Like senario 1, te eman urve for te prout markete as ig-quality (low-quality) prout sifts to te left (rigt) uner senario 2. However, sine, uner senario 2, bot (some) ig an low-quality prouers fin it optimal to proue aulterate prout an sell it as te ig-quality prout, te supply urves of te prout markete as ig-quality an te lowquality prout sift to te rigt an te left, respetively. Consequently, te effet of foo aulteration on te equilibrium quantity epens on te relative magnitue of te eman an supply effets of foo aulteration. However, te equilibrium onsumer prie an prie reeive by prouers of te prout markete as ig-quality (low-quality), like senario 1, erease (inrease) in te presene of foo aulteration senario 2 irrespetive of te relative magnitue of te eman an supply effets (see appenix I for etail). 13

15 Consumers Figure 5 epits te effets of foo aulteration on onsumer welfare. As sown earlier, in te presene of foo aulteration, te unertainty about te nature of te prout markete as igquality an te probability of getting sik, reue te utility assoiate wit te proution of prout markete as ig-quality. Consequently, te utility urve assoiate wit te proution of ig-quality prout U sifts to U, in te presene of foo aulteration. Moreover, in te presene of foo aulteration, te inrease equilibrium prie of te low-quality prout ereases te utility assoiate wit te onsumption of te low-quality prout. Terefore, te utility funtion assoiate wit te onsumption of te low-quality prout sifts ownwar from U l to U l,. Tus, te welfare of bot ig-quality an low-quality prout onsumers ereases wen te foo aulteration ours in te market. Prouers Figure 6 presents te effets of foo aulteration senario 1 on prouers. Sine, in te presene of foo aulteration, te equilibrium prie of te ig-quality (low-quality) prout ereases (inreases), te net returns urves assoiate wit te proution of te ig-quality prout an te low-quality prout sifts ownwar an upwar, respetively (ase an otte lines in figure 8, respetively). Te bol line in figure 8 presents te net returns assoiate wit te proution of aulterate prout. In tis ontext, te most effiient prouers (i.e., prouers wit Aε[0, A, )) fin it optimal to engage in frauulent beavior sine te net returns assoiate wit te proution of aulterate prout exee tose of te alternatives. Comparing te welfare effets in te absene an presene of foo aulteration iniates tat onest prouers wo ontinue to proue te ig-quality prout in te presene of foo aulteration (i.e., prouers wit Aε(A t,, A, )) lose. In ontrast, prouers benefiting te most from foo 14

16 aulteration are tose prouing te aulterate prout (i.e., prouers wit Aε[ 0, A, )), followe by prouers wo ontinue to proue te low-quality prout (i.e., prouers wit Aε(A, A l )). Like senario 1, in te presene of foo aulteration, te net returns urve assoiate wit te proution of te ig-quality (low-quality) prout sifts ownwar (upwar) uner senario 2. However, unlike senario 1, prouers wit te intermeiate level of effiieny (i.e., t prouers wit Aε(A,, A, )) fin it optimal to engage in frauulent beavior uner senario 2. Moreover, te most effiient prouers ave no inentive to engage in frauulent beavior uner tis senario. Like senario 1, wile prouers wo ontinue to proue te ig-quality prout t in te presene of foo aulteration (i.e., prouers wit Aε[ 0, A, )) lose, (many) prouers of / te aulterate prout (prouers wit Aε(A,, A, )) an prouers of te low-quality prout (i.e., prouers wit Aε(A,, A l )) are benefiting in te presene of foo aulteration (see figure 7) Mislabeling Compare wit te ase of foo aulteration, te main ifferene of mislabeling is tat te probability of getting sik if onsumers buy mislabele prout is zero. For instane, wen prouers mislabel a onventional apple as an organi apple, onsuming mislabele apple is not armful to uman ealt. Terefore, we an get te onsumer utility funtion in te presene of mislabeling by substituting te term (1 μ)εψ is equal to zero. Moreover, substituting w l + γa for β(w + δa) in equation 12 provies te net returns funtion for prouer in te presene of mislabeling. 15

17 Comparing te market an welfare effets of foo aulteration an mislabeling reveals tat te qualitative nature of analytial results is similar. However, te quantitative ifferenes in analytial results provie key insigts regaring eonomi impats uner foo aulteration an mislabeling. For instane, sine te probability of ealt azar is zero uner mislabeling, te reution (inrease) in te equilibrium prie of te ig-quality (low-quality) prout is lower uner mislabeling. Moreover, wile te equilibrium quantity of te ig-quality prout is iger in te presene of mislabeling, te frauulent beavior is more prevalent uner mislabeling tan uner foo aulteration (see supplementary material). 4. Government Problem Tis setion fouses on te esign of optimal poliy response to foo frau wen enforement is ostly. Te problem of te government an be seen as te etermination of te enforement poliy tat maximizes soial welfare. Speifially, te problem of te government is to etermine te optimal type an egree of poliy response in te presene of foo frau, knowing te ost an impat of its eision on all interest groups involve, i.e., onsumers, prouers, an taxpayers. Similar to Bonroy an Constantatos (2014), we assume tat te government as two poliy instruments to aieve optimal poliy response to foo frau: te positive ange in te ertifiation ost an te monitoring-punising system. 9 Te positive ange in te ertifiation ost an be aieve troug eiter an inrease in te ig-quality prout ertifiation ost or any new regulation wi inreases te ig-quality prout ertifiation ost su as foo traeability an ientity preservation. 10 Te level of monitoring-punising system is etermine by te auit probability φ 1 an te penalties ρ. Sine te penalties on etete mislabeling or aulteration are generally set elsewere in te legal system, tis enforement parameter is 16

18 exogenous to poliymakers (Giannakas an Fulton 2000; 2002). Speifially, te publi enforement ageny is assume to take penalties ρ as given wile oosing auit probability φ 1 to aieve te esire level of monitoring-punising system. Terefore, poliymakers ontrol te positive ange in te ertifiation ost f an te auit probability φ 1 to etermine te type an egree to wi frauulent beavior in te agri-foo marketing system is enfore. In tis setion, wile etermining te optimal poliy response to foo frau, bot senarios 1 an 2 are taken into aount. Regaring te welfare effets of foo frau, as sown earlier, wile bot isonest an low-quality prouers gain, onest ig-quality prouers always lose in te presene of foo frau. Intriguingly, albeit te presene of foo frau affets prouers ifferently, it is sown to reue te welfare of bot ig an low-quality prout onsumers. 4.1 Uner Foo Aulteration: Te government problem in te presene of foo aulteration is to maximize a non-equally weigte soial welfare funtion. In tis ontext, te government problem an be written as: (19) max k. CS + l 1. PS, + l 2. PS, + l 3. PS l, + m. [ωρn bρ φ 1 ψ PH] f,φ 1 => max k. CS (λ, P, (f), P l,, μ(f, φ 1, ρ)) + l 1. PS, (f, φ 0, φ 1, ρ) + f,φ 1 l 2. PS, (f, φ 0, φ 1, ρ) + l 3. PS l, (f, φ 0, φ 1, ρ) + m. [ω(φ 1 )ρn bρ φ 1 (k, l, m, ψ) ψ(s, n) PH(A (f, φ 0, φ 1, ρ), ε)] were te parameters PS,, PS,, an PS l, stan for surpluses of ig-quality, isonest, an low-quality prouers, respetively. Te onsumer surplus an te perentage of auite farms getting augt wile ommitting frau are CS an ω, respetively. 11 Te parameters n an ψ are te total number of prouers an te total ost of auiting all prouers, respetively. 12 Te 17

19 term ωρn aptures te revenue assoiate wit te monitoring an punisment of frauulent beavior of prouers, wile te osts of punisment, monitoring, an publi ealt are presente by te terms bρ, φ 1 ψ an PH, respetively. 13 In tis ontext, te taxpayer surplus in te objetive funtion is given by TS = [ωρn bρ φ 1 ψ PH]. Te weigt plae by te government on te welfare of onsumers, ig-quality prouers, isonest prouers, lowquality prouers, an taxpayers are k, l 1, l 2, l 3, an m, respetively. Te first orer onitions for te problem speifie in equation (19) are given as: (20) W = k CS f P, P, f + + k CS μ μ f + PS + l, 1 f PS + l, 2 f PS + l l, 3 f m PH A A f =0 => k CS μ μ f + l 1 PS, f PH A + m A f = k CS P, + l PS, P, f 2 + l PS l, f 3 f (21) + W = k CS φ 1 μ μ φ 1 + PS + l, 1 φ 1 PS + l, 2 φ 1 PS + l l, 2 φ 1 m PH A A φ m ω ρn φ 1 + mψ =0 => k CS μ μ φ 1 + l 1 PS, φ 1 + m PH A A + m ω PS ρn = l, φ 1 φ 2 1 φ 1 + l 2 PS l, φ 1 + mψ Equations (20) an (21) iniate tat te optimal poliy response to foo frau is etermine by equating te marginal benefits of enforement wit te marginal osts of enforement. Te marginal benefits of enforement in te presene of foo aulteration inlue inrease welfare of onsumers an onest prouers, an te penalties ollete on etete frauulent beavior. In ontrast, te marginal osts of enforement inlue erease welfare of isonest an low-quality prouers, an te ost of auiting an penalties. Result 1: Wen te most effiient prouers engage in frauulent beavior (Senario 1), an inrease in te ertifiation ost (a) oes not reue frauulent ativities, (b) ereases te average prout quality, an () ereases te supply of prout markete as ig-quality. 18

20 Figure 8.1 sows te eonomi impats of ertifiation uner foo aulteration wen te most effiient prouers engage in frauulent beavior. As sown previously, uner senario 1, prouers wit ifferentiating attributes Aε[0, A, ) engage in frauulent beavior, wile prouers wit ifferentiating attributes Aε(A t,, A, ) proue te ig-quality prout an t prouers wit ifferentiating attribute Aε(A,, A l, ) fin it optimal to proue te low-quality prout. In tis ontext, an inrease in te ertifiation ost will inrease bot te prie an proution ost of te ig-quality prout wit te inrease in ost exeeing tat in te prie. 14 Terefore, an inrease in te ertifiation ost uner senario 1 results in an inwar sift of te net returns urves assoiate wit te proution of te ig-quality an te aulterate prouts (i.e. e 2 sifts to e 3 an f 1 sifts to f 2, respetively). Te intersetion of te net returns urve assoiate wit te proution of low-quality g 1 an te net returns urve assoiate wit te proution of ig-quality prout e 3 etermines te new market supply of te prout markete t as ig-quality A,,f, ereasing te total supply of te prout markete as ig-quality by t A, t A,,f. Wile te supply of te prout markete as ig-quality ereases after inreasing te ertifiation ost, te supply of te aulterate prout remains te same sine te net expete benefit of frauulent beavior for most effiient prouers (i.e. prouers wit ifferentiating attributes Aε[0, A, )), remains te same. However, uner senario 1, foo frau an be ompletely eterre by inreasing te ertifiation ost in su a way tat te total ertifiation ost is equal to te ig-quality prie premium P, P l,. It is important to note tat, at tis ig ertifiation ost, tere will be no inentive for prouers to proue te igquality prout. 15 Terefore, wen te most effiient prouers are engage in frauulent beavior, an inrease in te ertifiation ost troug te introution of foo traeability, for 19

21 instane, oes not reue frauulent ativities. 16 Wat it oes reue te average prout quality in te market. Result 2: Wen prouers wit te intermeiate level of effiieny engage in frauulent beavior (Senario 2), an inrease in te ertifiation ost (a) reues frauulent ativities, (b) inreases te average prout quality, an () ereases te supply of prout markete as ig-quality. As sown previously, wen te net expete benefit of frauulent beavior ereases wit te effiieny of prouers (Senario 2, te total supply of prout markete as ig-quality inreases (supply effet of foo aulteration). On te oter an, in te presene of foo aulteration, te eman for ig-quality prout ereases (eman effet of foo aulteration). Figure 8.2 sows te effets of an inrease in te ertifiation ost uner senario 2 wen te supply effet ominates te eman effet of foo aulteration. In tis ontext, like senario 1, an inrease in te ertifiation ost by f results in inwar sift of te net returns urves assoiate wit te proution of ig-quality an aulterate foos (i.e. e 5 sifts to e 6 an f 3 sifts to f 4, respetively). Consequently, te intersetion of te new net returns urve assoiate wit te proution of aulterate foo f 4 an te net returns urve assoiate wit te proution of low-quality foo g 2 etermines te new supply of prout markete as ig- quality A,,f, wi is lower tan tat before inreasing te ertifiation ost. Unlike Senario 1, te total supply of aulterate prout ereases by A,,f A,, wile te total supply of ig-quality prout remains te same, improving te average prout quality in te market. Uner senario 2, an inrease in te ertifiation ost reues te net expete benefit of frauulent beavior an isourages frau. In partiular, wen an inrease in te ertifiation ost is su tat te net returns urves assoiate wit te proution of low-quality an aulterate prout interset at te point j 2, te net expete benefit of frauulent beavior for 20

22 all isonest prouers beomes eiter zero or negative, resulting in omplete foo frau eterrene. In tis ontext, te inrease in te ertifiation ost tat ompletely eters frauulent ativities is: (22) f = {δ (βδ + φ 1ρ)}[(P,,f w ) (P l, w l )] (δ γ){(βw + φ 0 ρ) w } {δ (βδ + φ 1 ρ)} It is important to note tat, wile an inrease in te ertifiation ost improves te average prout quality an reues frauulent ativities uner senario 2, an inrease in te ertifiation ost over f results in iminising average prout quality in te market. 17 Moreover, te qualitative nature of analytial results oes not ange wen we onsier te eman effet ominates te supply effet of foo aulteration uner senario 2. Te inrease in te ertifiation ost tat ompletely eters frauulent ativities wen te eman effet ominates te supply effet is: 18 (23) f = {(βδ + φ 1ρ) δ}[(p,,f w ) (P l, w l )] (δ γ)(w βw φ 0 ρ) {(βδ + φ 1 ρ) δ} Result 3: Wen te government wants to eter foo frau (wi is equivalent to maximizing te welfare of onsumers an/or welfare of onest ig-quality prouers), te optimal poliy response epens on te effiieny of isonest prouers an te relative osts of ifferent types of enforement. Te government plaes ig weigt on te welfare of onsumers an/or onest igquality prouers an positive but relatively low weigt on oter groups involve wen its objetive is to eter frau. Wen te weigt plae on onsumers an/or onest ig-quality prouers is signifiantly ig tat te benefits of enfoement exee te osts (i.e., marginal benefits of enforement marginal osts of enforement), te optimal poliy response is to inrease te enforement. 21

23 Senario 1 Figure 9.1 sows te effets of te monitoring-punising system wen te most effiient prouers are engage in frauulent beavior. Te slope of te net returns funtion assoiate wit te proution of aulterate prout (i.e., f 1 urve) is βδ + φ 1 ρ. Wen te government inreases te auit probability φ 1, te slope of te net returns funtion assoiate wit te proution of aulterate prout inreases wi, in turn, reues te net expete benefit of frauulent beavior. Terefore, wen te most effiient prouers are engage in frauulent beavior, te monitoring-punising system ereases te number of isonest prouers an improves te average prout quality in te market. It is important to note tat foo frau an be ompletely eterre uner senario 1 wen te slope of te net returns funtion assoiate wit te proution of aulterate prout beomes infinite (wi is equivalent to φ 1 ρ = ). Sine te auit probability φ 1 takes value between 0 an 1, it is not possible to ompletely eter foo frau uner senario 1 by inreasing te auit probability. However, wen ρ is enogenous to poliymakers, it is possible to ompletely eter foo frau by setting perfet monitoring-punising system. Speifially, te optimal oie is to establis small probability of ars punisment for te frauulent beavior in te agri-foo marketing system. Pose in a ifferent way, optimal oie, in tis ontext, is to set (φ 1 ρ) = in su way tat lim ρ (φ 1 = 0). 19 In ontrast, as sown in result 1, wen te most effiient prouers are engage in frauulent beavior, an inrease in te ertifiation osts oes not reue frauulent ativities but, instea, reues te market sare of te ig-quality prout. 22

24 Senario 2 In figure 9.2, te urve f 3 presents te net returns assoiate wit te proution of aulterate prout wen prouers wit intermeiate level of effiieny are engage in frauulent beavior. Like senario 1, an inrease in te auiting probability φ 1 inreases te slope of te urve f 3 (steeper), resulting in a reution in te net expete benefit of frauulent beavior. Wen te objetive of te government is to ompletely eter foo frau, te optimal oie is to inrease te auit probability φ 1 in su a way tat te f 3 urve intersets te point k, resulting in no benefit of frauulent beavior for all prouers. Speifially, te inrease in te auit probability tat ompletely eters frauulent ativities is: (δ γ)(p, βw φ 0 ρ) βδ [(P, w ) (P l, w l )] [δ(p l, w l ) γ(p, w )]] (24) φ 1, = [(P, w ) (P l, w l )]ρ Similar to an inrease in ertifiation osts, te monitoring-punising system an ompletely eter foo frau wen te prouers wit te intermeiate level of effiieny are engage in frauulent beavior. However, bot an inrease in te ertifiation ost an te monitoring-punising system are ostly for te soiety; te former reues te surpluses of onsumers an prouers, wile te latter inreases te taxpayer ost. Terefore, uner senario 2, wile foo frau an be ompletely eterre troug eiter inreasing te ertifiation ost or introuing a monitoring-punising system, te optimal poliy oie epens on te relative osts of ifferent types of enforement. Wile te monitoring-punising system reues te net expete benefit of frauulent beavior regarless of te relative effiieny of ifferent prouer groups, te effetiveness of an inrease in te ertifiation osts in eterring foo frau epens on te effiieny of isonest prouers. Speifially, an inrease in te ertifiation osts eters foo frau wen prouers wit intermeiate level of effiieny are engage in frauulent beavior; owever, it oes not 23

25 reue foo frau wen it is te most effiient prouers tat are engage in frauulent beavior. Terefore, wen te most effiient prouers ommit frau, te optimal poliy response is te monitoring-punisment system. In ontrast, te optimal poliy response epens on te relative osts of ifferent types of enforement wen prouers wit te intermeiate level of effiieny ommit frau. Put in a ifferent way, wile te government an, teoretially, eter foo frau troug a signifiant inrease in te ertifiation osts an/or monitoring-punising system, te optimal poliy response epens on te effiieny of isonest prouers an te relative osts of ifferent types of enforement. Result 4: Wen te government wants to inrease te average prout quality in te market wile eterring foo aulteration, te monitoring-punising system is better tan imposing iger ertifiation ost. Wile bot te monitoring-punising system an an inrease in te ertifiation ost reue te net expete benefit of frauulent beavior, te latter also inreases te proution ost of te ig-quality prout. Terefore, wile te monitoring-punising system always inreases te average prout quality, te effet of inreasing ertifiation osts on te average prout quality epens on te effiieny of isonest prouers. Senario 1 Uner senario 1, an inrease in te ertifiation ost reues te average prout quality. For example, inreasing te ertifiation ost by f raises te proution ost of ig-quality foo an onest prouers wit ifferentiating attribute Aε(A,,f, A, ) fin it optimal to swit from te proution of ig-quality to te proution of low-quality. Terefore, inreasing te ertifiation ost by f reues te total supply of ig-quality prout by A, A,,f,wi 24

26 wit te total supply of aulterate prout remaining te same, results in lower average prout quality (see Figure 8.1). Moreover, uner senario 1, foo aulteration an be ompletely eterre wen te government inreases te ertifiation ost in su a way tat te ertifiation ost is equal to te ig-quality prie premium (see Figure 8.1). However, tere is no inentive for prouers to proue ig-quality prout wen tere is no premium for tis prout. Put in a ifferent way, wen te ertifiation ost is equal to te ig-quality premium, te net returns urve assoiate wit te proution of ig-quality remains below te net returns urve assoiate wit te proution of low-quality for all prouers (i.e., prouers wit ifferentiating attribute Aε[0,1], resulting in te ig-quality prout being rove out of te market. Terefore, an inrease in te ertifiation ost ereases te average prout quality in te market uner senario 1. On te oter an, uner tis senario, te monitoring-punising system not only reues te frauulent beavior but also inreases te average prout quality. For instane, an inrease in te auit probability from φ 1 to φ 1 / sifts te net returns funtion assoiate wit te proution of aulterate prout from f 1 to f 2, ereasing te frauulent ativities. Consequently, te total supply of ig-quality prout inreases by A, A,,p (see Figure 9.1), improving tis way te average prout quality. Terefore, uner senario 1, wen te government wants to inrease te average prout quality in te market wile eterring foo aulteration, te monitoring-punising system is better tan imposing iger ertifiation osts. Senario 2 Wen prouers wit intermeiate level of effiieny engage in frauulent beavior (senario 2), an inrease in te ertifiation ost inreases te average prout quality. For instane, wen te supply effet ominates te eman effet of foo aulteration uner senario 2, an inrease in 25

27 te ertifiation by f reues te total supply of aulterate prout by A,,f A,, improving te average prout quality in te market. In tis ontext, te foo aulteration an be eterre wen an inrease in te ertifiation ost is su tat te net returns urves assoiate wit te proution of low-quality an aulterate foo interset at te point j 2. Consequently, t wile te total supply of ig-quality foo remains te same (i.e., A, ), te total supply of lowquality foo inreases by A, (see Figure 8.2). t A,, an te total supply of aulterate prout falls to zero Wen te government inreases auit probability to ombat foo aulteration in te market, te average prout quality also inreases. Speifially, wen te supply effet ominates te eman effet of foo aulteration uner senario 2, te frauulent ativities an be ompletely eterre by inreasing te auit probability in su a way tat φ 1 = φ 1,. Inreasing te auit probability to φ 1, results in eiter zero or negative net expete benefit of frauulent beavior regarless of te effiieny of prouers an inreases te total supply of t ig an low-quality prouts by A,,p A, an A, A,,p, respetively (see Figure 9.2). Comparing wit te ase of inreasing te ertifiation osts, te analysis reveals tat, wile frauulent ativities an be ompletely eterre troug eiter inreasing te ertifiation ost or te monitoring-punising system uner senario 2, te latter inreases te average prout t quality more sine it inreases te total supply of ig-quality prout by A,,p A, more tan tat of te former. Terefore, te monitoring-punising system is te optimal oie wen te government wants to inrease te average prout quality in te market wile eterring foo aulteration. Result 5: Wile te purity of labeling an be improve eiter troug an inrease in te ertifiation osts an/or te monitoring-punising system wen prouers wit te intermeiate 26

28 level of effiieny engage in frauulent beavior, te former ereases te purity of labeling wen te most effiient prouers engage in frauulent beavior. Aoring to Hamilton an Zilberman (2006), te purity of labeling an be efine as te proportion of ig-quality prout sales out of te total prout markete as ig-quality: 20 (25) p = x t x t +x were p is te level of purity taking values between 0 an 1; x t an x are te equilibrium quantities of ig-quality prout an aulterate prout, respetively. Senario 1 Wen te most effiient prouers engage in frauulent beavior, an inrease in te ertifiation ost oes not reue frauulent beavior, but ereases, instea, te purity of labeling. For instane, wen te ertifiation ost inreases by f, prouers wit ifferentiating attribute Aε(A,,f, A, ) swit from te proution of ig-quality to te proution of low-quality prout; wile all isonest prouers (i.e., prouers wit ifferentiating attribute Aε[0, A, )) ontinue to aulterate teir prout (see Figure 8.1). Terefore, an inrease in te ertifiation ost uner senario 1 ereases te purity of labeling by: (26) p f = p,f p,1 = {(βδ + φ 1 ρ) δ} + [(P f, + (w βw φ 0 ρ)(δ γ)f P f l, ) (w w l ) f] + f [(P,,f < 0 P f l, ) (w w l ) f] were p,1 an p,f present te level of purity in te market before an after inreasing te ertifiation ost uner senario 1, respetively. As sown previously, te monitoring-punising system reues frauulent beavior uner senario 1, wi, in turn, inreases te purity of labeling (see Figure 9.1). For instane, wen te government inreases te auit probability from φ 1 to φ 1 /, te purity of labeling inrease by: + 27

29 + + (27) p,mp = p,mp p,2 => p,mp = ρ(δ γ) (φ / 1 φ 1 ) > 0 were p,2 an p,mp present te purity of labeling uner te auit probability φ 1 an φ 1 /, respetively. Senario 2 Wen te prouers wit intermeiate level of effiieny engage in frauulent beavior, bot an inrease in te ertifiation ost an te monitoring-punising system inrease te purity of labeling in te market. For instane, te unit purity in te market an be aieve eiter troug inreasing te ertifiation ost by f or to inrease te monitoring-punising system by φ 1, (see equations 23 an 24). 4.2 Uner Mislabeling Result 6: Te level of enforement to eter foo frau epens on te effiieny of isonest prouers an te type of foo frau. Comparing te ig-quality prie premium uner mislabeling an foo aulteration, analytial results in te previous apter sow tat, wile te ig-quality prie premium ereases in te presene of foo frau, te fall in te ig-quality prie premium is lower uner mislabeling tan uner foo aulteration. Te ig-quality prie premium being iger uner mislabeling tan uner foo aulteration, results in iger prevalene of frauulent beavior uner mislabeling. Senario 1 As mentione earlier, te total number of isonest prouers is more uner mislabeling tan uner foo aulteration an te etetion probability is asymmetri. Terefore, te egree of auit probability uner mislabeling nees to be iger tan uner foo aulteration to eliminate 28

30 te inentive to ommit frau for all isonest prouers. Wen te penalties are enogenous to poliymakers, te foo frau an be ompletely eterre by enforing te perfet monitoringpunising system irrespetive of te foo frau type. As mentione previously, te optimal oie is to set severe punisment in su way tat lim ρ (φ 1 = 0). 21 Senario 2 Sine te ig-quality prie premium is iger uner mislabeling tan uner foo aulteration, an te etetion probability is asymmetri, te egree of enforement tat eliminates te inentive to ommit frau for all prouers is greater uner mislabeling tan uner foo aulteration. Speifially, te ifferene between te optimal egree of auit probability uner mislabeling φ 1,m an uner foo aulteration φ 1, is: 22 (28) φ 1,m φ 1, = {δ (βδ + φ 1ρ)}(P,m P, ) > 0 {(βw + φ 0 ρ) w }ρ iniating tat te optimal egree of auit probability is iger uner mislabeling tan tat uner foo aulteration. Similarly, te optimal level of ertifiation osts uner mislabeling an uner foo aulteration is: (29) f m f = (P,m P, ) > 0 implying tat te optimal inrease in te ertifiation ost is iger uner mislabeling tan uner foo aulteration. Terefore, te egree of enforement to eter foo frau epens on te effiieny of isonest prouers an te type of foo frau. 4.3 Corruption in te Publi Setor Te previous analysis an results are base on te assumption tat tere is no orruption in te publi setor, i.e., wen prouers are augt mislabeling or aulterating teir prout, tey will 29

31 fae te relevant penalty. Consier now te ase of a orrupt publi setor. By orruption tis stuy refers following two forms of orruption: politial orruption an bureaurati orruption. Politial orruption takes plae wen poliymakers use teir politial power to sustain teir status, power, an wealt (Amunsen 1999). Aoring to Transpareny International (TI), in te presene of politial orruption, it is private rater tan publi interests tat itate poliy eisions. On te oter an, te bureaurati orruption is efine as te orruption in publi aministration were publi offiials allow private agents privileges tat tey are not legally entitle to, in return for a payment (Akerman 1998). Te basi istintion between te politial an bureaurati orruption is tat te former ours at te stage of poliy eision wile te latter ours at te stage of poliy implementation. 23 Result 7: Wen te government onsiers te welfare maximization of isonest prouers, its optimal oie is no enforement. Wen te poliymakers are orrupt, te group of isonest prouers an influene te government poliy eisions troug lobbying, resulting laws an regulations regaring foo safety are systematially abuse by te orrupt poliymakers, ignore or tailore to maximize te welfare of isonest prouers. Speifially, wile maximizing welfare of te soiety, te orrupt poliymakers plae ig weigt on te welfare of isonest prouers an positive but relatively low weigt on onsumers, onest prouers, an taxpayers. Terefore, in tis ontext, te osts of enforement exee te benefits (i.e., marginal osts of enforement marginal benefits of enforement), implying omplete allowane of frauulent beavior. 24 Wen te penalties on etete foo frau are set elsewere in te legal system (i.e., are exogenous to te government), te only way te government an allow frauulent beavior is by setting = φ 1 = 0. Wile te government oes not spen resoures to etet frauulent beavior in tis ase, te 30