A Factor Influencing Network Formation: Link Investment Substitutability
49 Pages Posted: 1 Jan 2020
Date Written: December 13, 2019
Existing literature on network formation usually proceeds under one of the following two assumptions regarding how links between players are built: a pair of players choose whether or not to have a link with each other and the link forms if both sides say, or at least one side says, yes. The assumptions suffer from two limitations. First, they overlook the tendency that individuals not only decide who to link with but also how much to invest in each relationship. Second, they imply either a complete equal devotion into a link or a complete unequal devotion when real-life experiences often lie somewhere in between. I propose a general approach to link formation by allowing weighted link investment and adopting a CES link formation function. The CES function bridges the two commonly employed link formation assumptions and parametrizes a novel feature in link formation: link investment substitutability. I apply this approach to two well-known network formation models: the connections model and the law of the few model, and find that link investment substitutability has a great impact on network formation. In the connections model, I find that perfect substitutability between link investments reduces the strong tension between efficiency and stability characterized before to zero. In the law of the few model, I show that greater link investment substitutability makes players specialize in networking or other activities.
Keywords: Network Formation, Link Investment Substitutability, CES function
JEL Classification: D85, L14, C72
Suggested Citation: Suggested Citation