Network formation, asymmetry and equilibrium in monopolistic competition

Abstract

Thanks to the emergence of network theory, the view of the economy as a complex system of networks is gaining attention in economics. Nevertheless, complete connectedness between market actors is still a common assumption in economic modelling. In these models, there are no informational, spatial, or financial constraints on the establishment and maintenance of market relationships and the transactions that can be accessed through them. At the same time, economic sociology, network theory, and information economics argue that the standard assumption of complete connectedness is rather an extreme case of real economic functioning. In this paper, we investigate the results of introducing the assumption of incomplete connectedness into a classical monopolistic market model and, at the same time, allowing market actors to decide about their connections. Our results show that both sellers’ and buyers’ decisions on who to connect with naturally lead to the emergence of scale-free structures that characterize most real networks. Households prefer firms with low prices, and firms that produce at lower marginal cost can form more connections with households. For this reason, heterogeneous productivity causes differences in firms’ degrees. However, this relationship is nonlinear: limited product substitutability (product differentiation) and a symmetric distribution of firms’ marginal costs together result in an asymmetric degree distribution. Our results also suggest that the standard assumption of complete connectedness in models is not necessarily a reasonable assumption; the motivations of the actors are more in line with incomplete connectedness if transaction costs are present.