Working Paper: NBER ID: w26806
Authors: Arun G. Chandrasekhar; Melanie Morten; Alessandra Peter
Abstract: Entrepreneurs, particularly in the developing world, often hire from their networks: friends, family, and resulting referrals. Network hiring has two benefits, documented extensively in the empirical literature: entrepreneurs know more about the ability of their network (and indeed they are often positively selected), and network members may be less likely to engage in moral hazard. We study theoretically how network hiring affects the size and composition (i.e., whether to hire friends or strangers) of the firm. Our primary result is that network hiring, while locally beneficial, can be globally inefficient. Because of the existence of a network, entrepreneurs set inefficiently low wages, firms are weakly too small, rely too much on networks for hiring, and resulting welfare losses increase in the quality of the network. Further, if entrepreneurs are uncertain about the true quality of the external labor market, the economy may become stuck in an information poverty trap where forward-looking entrepreneurs or even entrepreneurs in a market with social learning never learn the correct distribution of stranger ability, exacerbating welfare losses. We show that the poverty trap can worsen when network referrals are of higher quality.
Keywords: Network Hiring; Entrepreneurship; Labor Market; Welfare; Information Poverty Trap
JEL Codes: D83; D86; J46; L14; O1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| network hiring (D85) | inefficient firm organization (D21) |
| network hiring (D85) | small firm size (L25) |
| network hiring (D85) | excessive reliance on network members for hiring (D85) |
| low wages (J31) | small firm size (L25) |
| low wages (J31) | welfare losses (D69) |
| uncertainty about external labor market quality (J29) | information poverty trap (I32) |
| information poverty trap (I32) | welfare losses (D69) |
| network quality (D85) | welfare losses (D69) |