Abstract
This paper shows that the relationship between social networks and cooperative trading is a two-way street. The possibility of cooperative trading enforced by third-party sanctions provides players with incentives to form costly links, and investing in costly links increases the power of third-party enforcement. In other words, the fact that trading is embedded in the social structure provides players with incentives to form costly links to internalize network externalities that arise from the fact that the structure of the network determines the interaction pattern and the information flows between players The paper also formalizes in game theoretic terms, the insight of Coleman's concerning the importance of closure for the emergence of cooperative behavior and explains how and why closure emerges. Based on this a formal definition of social capital is advanced, and it is shown that pair-wise equilibrium networks have the small-world property.
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