Models of network formation: Implications of network approach in labor markets

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School of Economics | Master's thesis
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Social networks play an important role in many significant economic relationships, and further in a wide range of interactions, including the transmission of job information, how much education one gets and how diseases spread. Networks affect the flow of information, which makes it critical to understand which networks structures are likely to emerge in an economy and how social network structures affect behavior. Networks have been long present in the sociology but the importance of networks in economics has not been acknowledged until the early 1990’s. Furthermore, the amount of social networking sites has increased rapidly during the past few years, which makes this field of research a very current issue. In this literature review, I dedicate a substantial part to study the various models of network formation. My other aim is to examine the very effects of networks, i.e. the emerged network structures to the economy. Here, I address the study especially on how networks affect job finding and how one can explain duration dependence of unemployment and persistent inequality of wages with the presence of networks. My goal is thus to show the importance of the network approach in economic theories with the labor market example. MAIN FINDINGS The first and the most known model in random graph literature is the static Erdös and Rényi (1959) model where the probability of link formation is Poisson distributed. Basic random graph model fails to replicate many features present in the real social networks such as clustering and “small-world” effects. One major shortcoming is the assumption of independent link formation; therefore e.g. models of homophilous networks have been developed. Random-graph models do not analyze the link formation process on agent level or the stability and efficiency as does strategic models; consequently, strategic models are more prevalent in the economic literature. Jackson and Wolinsky (1996) introduce the equilibrium concept of pairwise stability in their strategic formation model. Another pioneering one is the game theoretic, noncooperative model by Bala and Goyal (2000). Applications of game-theoretic models include dynamic models, network formation with heterogeneous agents and with endogenous link strength. Networks are a significant means of acquiring a job. There are labor market models implementing network approach with both fixed and variable network structure. Network approach explains the duration dependence of unemployment by the fact that longer history of unemployment is more likely to come when the direct and indirect connections of an agent are unemployed. Inequality explicated by networks appears in the difference of wage levels and dropout rates. Network approach provides a complementary theory to search model in deliberating labor market phenomena. The key merit of the network approach is the fact that it does not assume anonymous markets; the network structure determines which agents meet and operate together in the market. The impact of networks on information transmission patterns is supposedly significant because access to information is heavily influenced by social structure. Networks most likely reduce the problem of information asymmetry but it also causes individuals to have asymmetric positions in the economy with respect to access to information, which might result in persistent inequality between individuals. Networks might in fact be one source of market frictions. Within this light, networks deserve more attention in economic theories. One should also account for the growing role of Internet and institutions in the research.
networks, verkostot, formation models, muodostumismallit, labour market, työmarkkinat, anonymous markets, anonyymit markkinat, information transmission, informaation välittyminen