Anyone who has spent time in a developing country knows the importance of social connections. Among their many roles, these connections help individuals land jobs, and provide them with credit and other forms of support. At first glance, it would appear that connections distort the economy by giving select individuals an unfair advantage. However, modern economics has another explanation for this phenomenon, which turns this view on its head. When markets function imperfectly, networks of socially connected individuals can form to enhance economic efficiency. For example, when the ability of new hires cannot be observed by the firm, incumbent workers will refer competent members of their community to their employers. These new hires will not let down the workers that referred them, and will work diligently, to avoid the social sanctions they would face from their network if they were caught shirking. Social connections solve information and commitment problems in this example.
Working Paper
Anyone who has spent time in a developing country knows the importance of social connections. Among their many roles, these connections help individuals land jobs, and provide them with credit and other forms of support.