Network Formation with Endogenous Link Strength and Decreasing Returns to Investment

We study the formation of networks where agents choose how much to invest in each relationship. The benefit that an agent can derive from a network depends on the strength of the direct links between agents. We assume that the strength of the direct link between any pair of agents is a concave function of their investments towards each other. In comparison with some existing models of network formation where the strength technology is a convex function of investment, we find that (i) the symmetric complete network can dominate the star architecture in terms of total utility; (ii) a dominating symmetric complete network needs not be stable; and, (iii) star and complete networks can be dominated by small-world networks.

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