Networks as Enforcement

Companion to my job market paper, Smart Money, Closed Doors, which estimates the mechanism modelled here.

Abstract

Venture capital investors meet each other repeatedly: the partner on today's syndicate is a counterparty on tomorrow's deal. This paper models that repetition as a dynamic game and asks when it allows investors to sustain an implicit understanding not to fund companies that would compete with each other's portfolios. Deviation is punished the way it is punished in practice — by exclusion from future syndicates — so the network is simultaneously the channel through which deals flow and the instrument through which the agreement is enforced. I characterise the network structures that make such an understanding sustainable, and show that the relationship between market fragmentation and the scope for coordination is not the one standard oligopoly intuition suggests: a denser network of small investors can support more deterrence than a concentrated market of large ones. The model gives a dynamic foundation for the coordination parameter estimated in the companion paper, and generates predictions about which markets and which network positions should show the strongest entry deterrence.

Key ideas

1. Exclusion as the punishment — the credible threat behind an implicit agreement is losing access to future deal flow, not a price war.
2. The network is both the market and the enforcement technology — the same links that carry deals carry the punishment, so network structure determines what can be sustained.
3. Fragmentation need not restore competition — many small, densely connected investors can sustain deterrence that a few large, disconnected ones cannot.
4. A foundation for the empirical object — the model microfounds the coordination term that the job market paper estimates, and says where in the data it should be largest.

Resources

• Draft available on request
• Companion empirical paper — Smart Money, Closed Doors