Volume of trade and dynamic network formation in two-sided economies

Abstract

We study the long-run stability of trade networks in a two-sided economy. Each agent desires relationships with the other side, but having multiple partners is costly. This cost–benefit tradeoff results in each agent having a single-peaked utility over the number of partners–the volume of trade–the peak being greater for agents on one side than those on the other. We propose a stochastic matching process in which self-interested agents form and sever links over time. Links can be added or deleted, sometimes simultaneously by a single agent. While the unperturbed process yields each pairwise stable network as an absorbing state, stochastic stability in two perturbed processes provides a significant refinement, leading respectively to egalitarian and anti-egalitarian pairwise stable networks. These distinct network configurations have implications for the concentration on each side of the market of a random information shock, which may also affect structurally identical economies differently. The analysis captures stylized facts, related to herd behavior, market fragmentation, concentration and contagion asymmetry, in several two-sided economies. It also rationalizes long-run population imbalance between the two sides of most buyer–seller markets.