Social Embeddedness and Economic Governance: A Small World Approach

Abstract

We develop a framework that may be helpful for understanding the coevolution of social embeddedness and economic governance as an economy modernizes. We associate the transition from a traditional to a modern economy with an increase in the probability of interacting with individuals outside of a narrow relational neighbourhood. The small world framework, based on random graph theory, enables us to use this probability to interpolate the economy between a situation of close-knit group interaction and arms-length anonymous market interaction. This transition is accompanied by a decline in social embeddedness and can cause cooperation to collapse if the economy crosses a threshold before third party institutions emerge. Consequently, external institutions are crucial for market development to proceed beyond a threshold of complexity. The relative effectiveness of different institutions depends on the stage of modernization of the economy. Enforcement is relatively more valuable at low levels of modernization while information is relatively more valuable at high levels.

Keywords: economic governance, market development, social capital, institutions, small world

JEL Classification: L14, 017, D23, P51