A simple model on social connections, wages, and welfare

Abstract

In this paper, we develop a model of social connections to explore how, in the presence of social connections, an increase in an exogenous wage of one of the players does not necessarily lead to a Pareto improvement. Players are required to share resources to establish social connections. In this basic model, we show that the non-cooperative equilibrium is not Pareto efficient by introducing a compensation mechanism and showing that a Pareto improving trade could be made. We then show that if a wage increase for one player leads to a reduction in social connections, under some circumstances a mutually beneficial agreement could be reached in which the player foregoes the wage increase in exchange for a cash transfer. The model provides insights into why increases in income do not always translate into greater happiness.