Network-Based Hiring: Local Benefits; Global Costs

57 Pages Posted: 2 Mar 2020

See all articles by Arun G. Chandrasekhar

Arun G. Chandrasekhar

Stanford University - Department of Economics

Melanie Morten

Stanford University

Alessandra Peter

Princeton University

Date Written: February 2020

Abstract

Entrepreneurs, particularly in the developing world, often hire from their networks: friends, family, and resulting referrals. Network hiring has two benefits, documented extensively in the empirical literature: entrepreneurs know more about the ability of their network (and indeed they are often positively selected), and network members may be less likely to engage in moral hazard. We study theoretically how network hiring affects the size and composition (i.e., whether to hire friends or strangers) of the firm. Our primary result is that network hiring, while locally beneficial, can be globally inefficient. Because of the existence of a network, entrepreneurs set inefficiently low wages, firms are weakly too small, rely too much on networks for hiring, and resulting welfare losses increase in the quality of the network. Further, if entrepreneurs are uncertain about the true quality of the external labor market, the economy may become stuck in an information poverty trap where forward-looking entrepreneurs or even entrepreneurs in a market with social learning never learn the correct distribution of stranger ability, exacerbating welfare losses. We show that the poverty trap can worsen when network referrals are of higher quality.

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Suggested Citation

Chandrasekhar, Arun G. and Morten, Melanie and Peter, Alessandra, Network-Based Hiring: Local Benefits; Global Costs (February 2020). NBER Working Paper No. w26806, Available at SSRN: https://ssrn.com/abstract=3547154

Arun G. Chandrasekhar (Contact Author)

Stanford University - Department of Economics ( email )

Landau Economics Building
579 Serra Mall
Stanford, CA 94305-6072
United States

Melanie Morten

Stanford University ( email )

Stanford, CA 94305
United States

Alessandra Peter

Princeton University ( email )

22 Chambers Street
Princeton, NJ 08544-0708
United States

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