A model of inter-organizational network formation

TL;DR

This paper introduces an equilibrium model of inter-organizational network formation using a strategic game framework, estimating payoffs with Bayesian methods, and applying it to venture capital co-investment networks to analyze effects of shocks.

Contribution

It develops a novel equilibrium framework for network formation, characterizes networks as ERGMs, and demonstrates how to interpret economic factors and simulate policy impacts.

Findings

Firms prefer forming ties with similar firms and rely on joint partners.

Network density and clustering increase with firm entry and regulatory shocks.

The approach enables economic interpretation and policy simulation of network dynamics.

Abstract

How do inter-organizational networks emerge? Accounting for interdependence among ties while studying tie formation is one of the key challenges in this area of research. We address this challenge using an equilibrium framework where firms' decisions to form links with other firms are modeled as a strategic game. In this game, firms weigh the costs and benefits of establishing a relationship with other firms and form ties if their net payoffs are positive. We characterize the equilibrium networks as exponential random graphs (ERGM), and we estimate the firms' payoffs using a Bayesian approach. To demonstrate the usefulness of our approach, we apply the framework to a co-investment network of venture capital firms in the medical device industry. The equilibrium framework allows researchers to draw economic interpretation from parameter estimates of the ERGM Model. We learn that firms rely on their joint partners (transitivity) and prefer to form ties with firms similar to themselves (homophily). These results hold after controlling for the interdependence among ties. Another, critical advantage of a structural approach is that it allows us to simulate the effects of economic shocks or policy counterfactuals. We test two such policy shocks, namely, firm entry and regulatory change. We show how new firms' entry or a regulatory shock of minimum capital requirements increase the co-investment network's density and clustering.