Network Formation under Multiple Sources of Externalities

Abstract The architecture of social and economic networks is often explained in terms of the externalities shaping the link‐forming incentives of players. We make two contributions to this literature. First, we bring into its ambit the linear‐quadratic utility model. Since players' utilities are now a function of their network centralities, this permits endogenizing their locational incentives in a network. Second, we show that the mode of transmission of externalities can be crucial in dictating the topology of equilibrium networks. We consider two alternative modes for channeling externalities. Both have the same primary source (direct links) but a different secondary source (global effects vs. indirect links). We characterize equilibrium networks for different positive–negative combinations of primary–secondary externalities for both modes. We show that the mode of transmission influences the equilibrium architecture when externalities from the primary source are positive ; when these externalities are negative, the equilibrium network is empty.