The Economics of Counterfeiting

with Elena Quercioli

See also the blog piece:  The Economics of Counterfeiting

This paper develops a new tractable strategic theory of counterfeiting as a multi-market continuum-player game played by good and bad guys. There is free entry of bad guys, who choose whether to counterfeit, and what quality to produce. Opposing them is a continuum of good guys who select a costly verification effort. Counterfeiting equilibrium consists of a "cat and mouse'' game between effort and quality, and a collateral "hot-potato'' passing game among good guys. With log-concave verification costs, counterfeiters producer better quality at higher notes, but verifiers try sufficiently harder that the verification rate still rises. We prove that the unobserved counterfeiting rate is hill-shaped in the note, vanishing at extremes. We also deduce all comparative statics graphically.

Our theory applies to fixed-value counterfeits, like checks, money orders, or money. Focusing on counterfeit money, we assemble a unique data set from the U.S. Secret Service. We identify key time series and cross-sectional patterns, and explain them: 

(1) the ratio of all counterfeit money (seized or passed) to passed money rises in the note, but less than proportionately;

(2) the passed-circulation ratio rises in the note, and is very small at $1 notes;

(3) the vast majority of counterfeit money used to be seized before circulation, but now most passes into circulation;

and (4) the share of passed money found by Federal Reserve Banks generally falls in the note, as does the ratio of the internal FRB passed rate to the economy-wide average.

Our theory explains how to estimate  from data both the street price of counterfeit notes and the small costs of verifying counterfeit notes. 

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