Financial Pyramids in Transitional Economies: A Game-Theoretic Approach

We analyse the phenomenon of financial pyramids (Ponzi games) that were surprisingly widespread in transitional economies in the mid-1990s. Financial pyramids are modelled as a stochastic game under incomplete information between a Ponzi firm — an intended builder of the pyramid — and a population of heterogeneous individual investors. It is shown that although equilibrium strategies involving individual decision to invest may exist in stage-games, the whole dynamic game has no equilibrium except a trivial one, in which nobody invests, and thus the pyramid does not grow. Thus, individual decisions to invest are attributable to either naive belief in the firm's honesty or to an inappropriate specification of the dynamic optimization problem. Several plausible dynamics of population behaviour, especially those resulting from evolutionary games, are proposed and compared to the actual experience of Russia