Formation of trade networks by economies of scale and product differentiation

TL;DR

This paper models how trade networks form based on rational decisions influenced by economies of scale, product differentiation, and costs, revealing three distinct network structures through simulations and analytical methods.

Contribution

It introduces a rational-agent based model for trade network formation incorporating heterogeneity, costs, and scale effects, with analytical insights into regime transitions.

Findings

Identifies three macro regimes: star-like, all-to-all, and local production networks.

Shows how costs and preferences influence network structure.

Provides critical parameter estimates for regime transitions.

Abstract

Understanding the structure and formation of networks is a central topic in complexity science. Economic networks are formed by decisions of individual agents and thus not properly described by established random graph models. In this article, we establish a model for the emergence of trade networks that is based on rational decisions of individual agents. The model incorporates key drivers for the emergence of trade, comparative advantage and economic scale effects, but also the heterogeneity of agents and the transportation or transaction costs. Numerical simulations show three macroscopically different regimes of the emerging trade networks. Depending on the specific transportation costs and the heterogeneity of individual preferences, we find centralized production with a star-like trade network, distributed production with all-to-all trading or local production and no trade. Using methods from statistical mechanics, we provide an analytic theory of the transitions between these regimes and estimates for critical parameters values.