Economics of networks

This term should not be confused with network economics or network externality.

Models of networked markets

The concept of networks enables a better understanding of the functioning of markets. On the border of network science and market theory, several models have emerged to explain different aspects in markets.

Exchange theory

Exchange theory explains how economic transactions, trade in favor, communication of information, or other exchanges are affected by the structure of the relationships among the involved participants. The main idea is that the act of exchange is influenced by the agents’ opportunities and their environment. For example, the position of a given agent in the network can endorse them with the power in the auctions and deals they make with their partners.

Bilateral Trading Models

As part of exchange theory, bilateral trading models consider sellers and buyers. These models use game-theoretic models of bargaining in networks to help predict the behavior of agents depending on the type of network. The outcome of transactions can be determined by, for instance, the number of sellers a buyer is connected to, or vice versa (Corominas-Bosch model). Another case occurs when the agents agree on a transaction through an auction and their decision-making during the auction depends on the link structure. Kranton and Minehart concluded that if markets were considered networks, it would enable sellers to pool uncertainty in demand. Building links is costly, however, due to trade-offs not all links are necessary for the network, resulting in a sparse, efficiency-enhancing network.

Informal exchange

The study of networks in economics started before the development of network science. Károly Polány, Claude Lévi-Strauss, and Bronislaw Malinowski studied tribes where complicated gift exchange mechanisms constructed networks between groups, such as families or islands. Although modern trade systems differ fundamentally, such systems based on reciprocity can still survive and reciprocity-based or personalized exchange deals persist even when a market would be more efficient. According to Kranton, informal exchange can exist in networks if transactions are more reciprocal than market-based. In this case, market exchange is hard to find and is associated with high search costs, therefore yielding low utility. Personalized exchange agreements ensure the possibility of long-term agreements.