Alexander Henke, Fahad Khalil, and Jacques Lawarree

We present a principal–auditor–agent model with adverse selection where the agent can bribe the auditor and the auditor can extort the agent. We show that it is optimal to deter extortion but allow bribery, and we analyze the impact of honest agents in this setting. Unlike strategic agents, honest agents refuse to bribe and therefore cannot reap the benefit of bribery. This unwillingness to bribe raises the cost of participation of honest agents and creates a negative externality by offering a scope for rent to all strategic agents. This negative externality is larger when an agent’s bargaining strength is higher. We find that the principal’s payoff is nonmonotonic in honesty, and increasing honesty is helpful only if it is widespread enough, leading to a potential corruption trap. We also show that an increase in productivity lowers the threshold for honesty to be beneficial.