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This paper introduces a new model of exchange: networks, rather than markets, of buyers and sellers. It begins with the empirically motivated premise that a buyer and seller must have a relationship, a "link," to exchange goods. Networks-buyers, sellers, and the pattern of links connecting them-are common exchange environments. This paper develops a methodology to study network structures and explains why agents may form networks. In a model that captures characteristics of a variety of industries, the paper shows that buyers and sellers, acting strategically in their own self-interests, can form the network structures that maximize overall welfare. (JEL DOO, LOO)
This paper develops a new model of economic exchange: networks, rather than markets, of buyers and sellers. In contrast to the assumption that buyers and sellers are anonymous, this paper begins with the empirically motivated premise that a buyer and seller must have a relationship, or "link," to engage in exchange. Broadly defined, a "link" is anything that makes possible or adds value to a particular bilateral exchange. An extensive literature in sociology, anthropology, as well as economics, records the existence and multifaceted nature of such links. In manufacturing, customized equipment or any specific asset is a link between two firms.1 Relationships with extended family members, coethnics, or "fictive kin" are links that reduce information asymmetries.2 Personal connections between managers and bonds of trust are links that facilitate business transactions.3 There is now a large body of research on how such bilateral relationships facilitate cooperation, investment, and exchange. Some research also considers how an alternative partner or "outside option" affects the relationship. However, there has been virtually no attempt to examine the realistic situation in which both buyers and sellers may have costly links with multiple trading partners.
This paper develops a theory of investment and exchange in a network, where a network is a group of buyers, sellers, and the pattern of the links that connect them. An economic theory of networks must consider questions not encountered when buyers and sellers are assumed to be anonymous. Because a buyer can obtain a good from a seller only if the two are linked, the pattern of links affects competition for goods and the potential gains from trade. Many new questions arise: Given a...