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Monday, August 23, 2004

Are we talking to ourselves here, or what?

This was recently brought to my attention:

August 22, 2004


It's Who You Know. Really.


In many economics faculty lounges, the mere suggestion that markets are something less than efficient is likely to elicit cool stares. But Kenneth J. Arrow, a 1972 Nobel laureate and professor emeritus at Stanford, recently turned a skeptical eye on the efficiency of one vast market - the labor market - and reached some intriguing conclusions about what distinguishes better-paid workers from their lower-paid peers. It's not what you know, Professor Arrow, a prolific theorist, suggests; it's who you know.

If labor markets were truly efficient, pay among workers with similar credentials would not vary much. But within groups of similarly situated workers, income inequality has risen in recent decades. What's more, Professor Arrow said, "Observable characteristics like intelligence, education, experience and age explain only half of the difference."

To get at the other 50 percent, he and a Stanford colleague, Ron Borzekowski, now at the Federal Reserve in Washington, reimagined the place of workers in the equation. Instead of regarding employees' wages as responses to the laws of supply and demand, they constructed a model that views wages as functions of competitive bidding among companies.

A computer connected to 100 computers is economically more powerful than a PC linked to only 10 - that's the network effect. It turns out that the same holds for workers and their personal connections to companies. While the Internet's breadth may offer individuals the chance to post their qualifications for millions of employers to see, about half of all jobs are still found through personal contacts of some sort.

And the more connections you have, the more you end up being paid. Why? Companies that make judgments based solely on a résumé are flying blind, to a degree. By contrast, if a job applicant once worked with a current company employee, or attends the same church as a company worker, the company can glean hints about how that applicant will perform. Such personal information - about reliability, or a sense of humor - can lead companies to bid more aggressively for someone's services. But such data is conveyed almost exclusively through personal network connections. And if the information is available to 10 potential employers instead of 2, wages are more likely to be bid higher.

The network effect is weaker, though, for people seeking the most highly skilled positions.

"For jobs that require higher education and technical skills, network connections don't matter as much," said Harry J. Holzer, professor of public policy at Georgetown University. Honors graduates of Harvard Law School will probably receive a host of job interviews, regardless of how many partners they know at how many law firms. But, Professor Holzer said, when it comes to relatively unskilled jobs, such links are crucial. When hiring a baby-sitter, the fact that an applicant may have worked for a neighbor or relative carries far more weight than a résumé.

In fact, in a recent working paper, Professor Arrow and Mr. Borzekowski conclude that a worker's net worth can have a lot to do with the worker's network. In their model - and it is just a model, not based on empirical data - a person with one corporate connection would be expected to earn $19,570. By contrast, a person with links to five companies would be expected to earn $30,410. Ultimately, they conclude, "the difference in the number of ties can induce substantial inequality and can explain 15-20 percent of the unexplained variation in wages."

The economists also suggest that network effects may help account for income inequality among races. In 1998, for men 24 to 40 years of age who had finished high school but had no further education, the average income for African-Americans was $26,223 and for whites was $33,123. If one hypothesized that the average African-American worker had links to 3.2 companies and the average white worker had links to 5.7, that would go a long way toward explaining the large wage gap, Professor Arrow said.

THE hypothesis makes sense, said Jeffrey A. Robinson, assistant professor of management and entrepreneurship at New York University's Stern School of Business. "Minorities are often disconnected from the web of social relationships that lead to hiring decisions."

Professor Arrow has not pursued the policy implications of his findings, but others have. To improve the lot and prospects of middle-income workers and the working poor, it may not be enough merely to focus on the traditional twin pillars of job training and education. Policy makers may also need to focus on upgrading the number and quality of workers' links to companies.

"The challenge is to expand the role of social brokers - individuals, nonprofit and government agencies - that can facilitate connections to companies once people have the skills," Professor Robinson said.

Daniel Gross writes the "Moneybox" column for

To steal a concept from the guys over at Penny Arcade, my brain is about to explode out of my head. I'm pleased to see that the economists have finally caught up to sociology. Did they find back issues of our journals at a yardsale or something? I mean, I'm glad to have the confirmation, but we've been doing this exact sort of research for decades now. Think I'm being too harsh? Well, keeping in mind that this won't be an exhaustive list by a longshot, let's go ahead and see:

We start with Mark Granovetter's seminal piece "The Strength of Weak Ties," which was published in 1973. That one argues that who you know can play a big part in how you find work, particularly good paying work. Specifically, it argues that it isn't your strong ties (Emotionally close associates, or those you speak to regularly) that bring you useful new information, but rather it's your weak ties.

Mark Granovetter decided to elaborate on the concept of ties in economics even more in 1985, when he published "Economic Action and Social Structure: The Problem of Embeddedness," which makes the useful point that while ties can allow a hiring body to gain more information on a prospective employee, they may also enable that employee to take advantage of the company to some degree. Thus, social ties are not entirely beneficial, but represent a double-edged sword.

James Montgomery got into the act with his paper, "Job Search and Network Composition: Implications of the Strength-of-Weak-Ties Hypothesis" in 1992. This piece looks at the effects of ties on the pay acquired by a job candidate. Needless to say, he finds an effect.

Also in 1992 we find Ron Burt's "Structural Holes: The Social Structure of Competition," which is a lot like Granovetter's 1973 article, except written in book form, with more math, and directed at management consultants as much as academics. It also provides empirical validation of the idea that networks matter for individual and collective success, and he even offers suggestions to the ambitious executive.

Montgomery followed that one up in 1994 with "Weak Ties, Employment, and Inequality: An Equilibrium Analysis" which looks at whether or not distributions of social ties can have a significant effect on the overall inequality in the system.

Brian Uzzi took a look at networks in the New York apparel sector in 1997 with his article "Social Structures and Competition in Interfirm Networks: The Paradox of Embeddedness" in which he essentially confirmed Granovetter's predictions from 1985, and in the process added considerable detail to our concepts of how networks are important.

Of course there's Paul DiMaggio and Hugh Louch's 1998 study "Socially Embedded Consumer Transactions: For What Kinds of Purchases do People Most Often Use Networks?" which finds that people on the consuming end of the economic transaction also make use of different types of networks to reduce uncertainty and improve outcomes.

Brian Uzzi once more made a useful contribution with his 1999 "Embeddedness in the Making of Financial Capital: How Social Relations and Networks Benefit Firms Seeking Financing" in which he looked at how social ties can be beneficial for entire companies that are seeking to either gain access to financial capital, or are seeking to secure their investment in another corporation.

Most beautifully we have the book "Networks and Markets," edited by James Rauch and Alessandra Casella (2001) which is actually composed of alternating chapters written by either a sociologist or an economist. This book, as the title suggests, explores the interaction of social networks and markets, using approaches ranging from theoretical analyses of networks (Ron Burt), to case studies of Taiwan and South Korea (Robert C. Feenstra, Gary G. Hamilton & Deng-Shing Huang), to historical analysis in renaissance Florence (John F. Padgett), to the organization of fish markets (Alan Kirman).

And, of course, here in 2004 we have W.E. Baker and R.R. Faulkner's article "Social networks and loss of capital," which takes a look into the positive and negative effects of social ties for those investing in companies engaging in fraud. Put another way, they could have titled their article "How not to get screwed by Enron."

So, in short, I'm thrilled that Kenneth Arrow has discovered networks and I'm thrilled that he agrees with us. I just wonder how all this happened. Is this an example of convergent evolution? Did he recently pick up an old issue of the American Sociological Review, where many of the articles I just listed were published? Did the author of the article, Daniel Gross, neglect to mention that a Nobel Laureate economist was simply confirming the findings of some plain, old, regular sociologists? Will Kirby escape from the dastardly clutches of the evil Dr. Venomtongue? I'm just curious here.

As for all you kids over in the Public Sociology camp, I'll tell you this: you've got your work cut out for you.


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