Relationship Externalities

Abstract

We study a model of network externalities transmitted over links wherein the externalities stem from links themselves rather than nodes. For example, bilateral investments can fail and trigger cascading defaults of firms. Joint research projects can succeed and innovations can be diffused over the network. We characterize stable and efficient networks. Under negative externalities, disjoint cliques are stable and efficient. Under positive externalities complete networks and star networks are stable. Efficient networks feature are a mix: pineapple networks which consist of one large clique and a star network appended to each other.

Keywords: Network Formation, Stability, Strong Stability, Externalities

JEL Classification: D62, D85