Employee Theft, Audits, and the Role of Legal Institutions: A Game-Theoretic Analysis

Abstract This paper analyzes theft committed by employees against their employers using a dynamic game-theoretic model. The model features a first-period normal form game between the employee and the employer (firm) and incorporates the active roles of the prosecutor’s office and the judiciary in subsequent stages. A key contribution is the analysis of the firm’s strategic decision to report the crime, which is influenced by potential public exposure costs. We demonstrate two primary findings. First, if the judicial process is sufficiently short and the punishment is sufficiently high, the unique subgame perfect Nash equilibrium is for the firm to audit and the employee not to commit fraud. This deterrence result holds independently of the statute of limitations. Second, if the costs of public exposure are sufficiently high, the firm will strategically choose not to appeal to the public justice system, even after detecting theft. In this scenario, internal auditing alone is not sufficient to curb employee fraud.