Relationship Externalities

Abstract

We propose a model of network formation where agent’s payoffs depend on the connected component they belong to in a way that is specific enough to be tractable yet general enough to accommodate a number of economically relevant settings. Among them are formation in the presence of contagion via links and collaboration with spillovers. A key feature of this setting is that the externalities stem from links rather than nodes. 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 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