This paper develops a search model with heterogeneous workers and social networks.

High ability workers are more productive and have a larger number of professional contacts.

Firms have a choice between a high cost vacancy in the regular labour market and a low cost

job opening in the referral market. In this setting the model predicts that a larger number of

social contacts is associated with a larger wage gap between high and low ability workers and

a larger difference in the equilibrium unemployment rates. Next we demonstrate that the

decentralized equilibrium is inefficient for any value of the bargaining power. There are two

reasons for the inefficiency. First, the private gain from creating a job in the referral market

is always below the social gain, so the equilibrium unemployment of high ability workers is

above its optimal value. Moreover, high ability workers congest the market for low ability

workers, so the equilibrium wage inequality is inefficiently large. This is in contrast to the

result of Blazquez and Jansen (2008) showing that the distribution of wages is compressed

in a search model with heterogeneous workers. Finally, we show that a combination of taxes

and subsidies can restore the optimal allocation.