The old-boy network and the quality of entrepreneurs

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Official URL: http://dx.doi.org/10.1111/j.1530-9134.2010.00273.x

We study a model of network formation and start-up financing with endogenous entrepreneurial type distribution. A hub firm admits members to its network based on signals about entrepreneurs' types. Network membership is observable, which allows lenders to offer different interest rates to network and stand-alone entrepreneurs. We show that a network outcome can display a smaller number of high-type entrepreneurs even though the network is neither nepotistic nor informationally disadvantaged. Although a welfare-improving network can emerge as a technically stable or unstable equilibrium, one that decreases welfare is always formed by a technically unstable equilibrium. However, the adverse welfare effects of a network and its corresponding type configuration may persist because ex post high-type entrepreneurs prefer to stay high type whereas those who wish to become high type may need some time to react.