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The Formation of Networks with Local Spillovers and Limited Observability

Jan 2012
Working Paper
11-004
By  Michael Koenig
In this paper I analyze the formation of networks in which each agent is assumed to possess some information of value to the other agents in the network. Agents derive payoff from having access to the information of others through communication or spillovers through the links between them. Linking decisions are based on network-dependent marginal payoff and a network independent noise capturing exogenous idiosyncratic effects. Moreover, agents have a limited observation radius when deciding to whom to form a link. I find that for small noise the observation radius does not matter and strongly centralized networks emerge. However, for large noise, a smaller observation radius generates networks with a larger degree variance. These networks can also be shown to have larger aggregate payoff. I then estimate the model using a network of coinventors, firm alliances and trade relationships between countries, and find that the model can closely reproduce the observed patterns. The estimates show that with increasing levels of aggregation, the observation radius is increasing, indicating economies of scale in which larger organizations are able to process greater amounts of information.