Networks influence human behavior and well-being, and, realizing this, individuals make conscious efforts to shape their own networks. Over the past decade, economists have combined these ideas with concepts from game theory, oligopoly, general equilibrium, and information economics to develop a general framework of analysis. The ensuing research has deepened our understanding of classical questions in economics and opened up entirely new lines of enquiry.

INTRODUCTION

Our life takes place at the intersection of the global and the local: we function in a world dominated by large firms and international markets, but we also inhabit small and overlapping neighborhoods of friends and family, colleagues and collaborators. Game theory is well suited for the study of behavior in small exclusive groups while general equilibrium theory provides a sophisticated approach to the understanding of large anonymous systems. Networks offer us a framework that combines local interactions within large interconnected populations. In doing so, they fill an important gap in the toolkit of economists.

The key methodological innovation of the early research on networks in the 1990s was the introduction of graph theory alongside purposeful agents. Two ideas were central: the study of how the network architecture shapes human behavior and the study of how purposeful individuals form links and thereby create networks. Over the past decade, economists have developed models that include networks, alongside the familiar notions of strategy, information, prices and competition. These models are now being applied to address an increasingly ambitious range of questions in economics. I see here a close analogy with the spread of game theory in economics, during the 1980s and 1990s, in one applied field after another.

I begin by developing notation and basic concepts on networks in Section 2. Section 3 outlines a framework that combines individual choice, networks and markets, while Section 4 introduces the elements of an economic theory of network formation.

The rest of the paper is devoted to a discussion of economic applications. There has been very rapid growth in research in this field over the last decade. In my presentation, I will favor lines of work that explicitly combine network ideas with familiar models of markets.