Understanding labour markets

Economics Nobel for advocating greater government oversight

The Nobel Prize in Economic Science for 2010 has been awarded to two Americans, Peter Diamond of the Massachusetts Institute of Technology and Dale Mortensen of Northwestern University, along with a naturalised Briton, Christopher Pissarades, for their work in search theory, which, among other applications, rigorously explains the coexistence of unemployment and job vacancies in market economies. The award has been widely hailed given the centrality of the theory to provide a macroeconomic analysis of the labour market. While the underpinnings of the theory were established by Diamond in the early 1970s, Mortensen and Pissarades have deepened the theory later.

Search theory had its origins in the 1960s motivated by the need to provide an explanation for discrepancies between neoclassical theory with its emphasis on markets with perfect information and zero search costs, with empirical findings emerging from studies of the labour and housing markets in the United States. Buyers and sellers of goods and services do not immediately find what they are looking for and even when they do, are likely to reject the outcome as sub-optimal. Consequently, the processes of searching and finding inherently involve “friction”, which raises costs for both buyers and sellers.

Diamond’s seminal 1971 paper modelled the interaction between buyers looking for the best possible price and sellers who would set prices taking buyers’ search behaviour into account. The introduction of search costs led to conclusions that differed sharply from established theory. Mortensen and Pissarades, who followed Diamond a decade later, published several influential studies on search and matching markets. Their work led to the identification of “external effects” that are not taken into account by individual agents. It followed that unregulated search markets in general were more inefficient in that they encouraged sub-optimal utilisation of resources. Another insight was the discovery that with search costs, the unregulated outcome was not uniquely efficient. The policy advice that intuitively followed was for greater government oversight, especially in situations where greater control would curb search-related inefficiencies.

The most conspicuous applications of search theory have been to the macroeconomic dynamics of labour markets. The Diamond-Mortensen-Pissarades (DMP) model is arguably the most commonly used analytical tool for analysing unemployment, wage formation and job vacancies. The model has been used to estimate the effects of different labour markets on unemployment, the average durations of employment spells, the number of vacancies and the real wage. Search theory has also formalised the intuitive belief that generous unemployment benefits reduce the incentive to seek employment, thereby increasing the search time. While the theory’s most visible contribution has been to labour markets, it has broader applications in public economics, monetary economics and the economics of housing markets. The assumption of institutional arrangements, such as social security and unemployment insurance, within the theoretical framework largely restricts its applicability to developed economies. However, its utility in providing the intellectual foundation for the analysis of markets characterised by distortions by way of information asymmetries cannot be diminished.