Network-based Hiring: Local Benefits; Global Costs

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 subsequently, workers from the network 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 run firms that are weakly too small, rely too much on networks for hiring, and have resulting welfare losses that 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.