Innovators of search market

The Nobel Prize in Economic Sciences for 2010 was awarded jointly to Peter A Diamond, then at Massachusetts Institute of Technology, Dale T Mortensen, then at Northwestern University and Christopher A Pissarides, then at London School of Economics 'for their analysis of markets with search frictions'.

Diamond did his undergraduate in Mathematics from Yale University in 1960 and a PhD in economics from the Massachusetts Institute of Technology (MIT) in 1963. After his Doctorate, he joined as an Assistant Professor of Economics at the University of California, Berkeley, and stayed there till 1966, before returning to MIT as an associate professor. Diamond also acted as a research associate of the National Bureau of Economic Research from 1991 and held several other academic and editorial posts.

Mortensen received his BA in economics from Willamette University, Oregon in 1961 and his PhD in Economics from Carnegie Mellon University in 1967. Even before he finished his doctorate, he joined the faculty of Northwestern University in 1965. He became a professor of Managerial Economics and Decision Sciences at the Kellogg School of Management in 1980. He was also the Niels Bohr Visiting Professor at the School of Economics and Management, Aarhus University, from 2006 to 2010. Mortensen was also a visiting professor at several schools, including Cornell and New York University and the Soviet Academy of Sciences, and he served in an editorial or advisory capacity with such organizations as the American Economic Association.

Pissarides did his bachelor's and master's degrees in economics from the University of Essex in 1970 and 1971, and a PhD in economics from the London School of Economics in 1973, under the supervision of the mathematical economist Michio Morishima for a thesis entitled 'Individual behaviour in markets with imperfect information.' After his doctorate, he worked briefly at the Central Bank of Cyprus and then became a lecturer in economics at the University of Southampton. In 1976 he joined LSE as a faculty.

The three Nobel laureates formulated a theoretical framework for search markets, such as the job market, in which buyers and sellers do not always make contact with one another immediately. Their models help explain how unemployment, job vacancies and wages are affected by economic regulations and could help guide government policy to find the best solution. In this article, we will review the main works of the three laureates and see how they continue to guide us in the formulation of public policy.

Main works of Diamond

Diamond has been a versatile economist with works ranging from public finance (optimal taxation), 'search theory' in labour economics, social security and pension reform and behavioural economics.

In public finance, Diamond has worked on issues such as national debt and its impact and optimal taxation. In a 1960s paper, he argued that a rising national debt can slow down growth in the long run. In the early 1970s, Diamond's work on optimal taxation became famous. In 1971, his paper, co-authored with Mirrlees, titled 'Optimal Taxation and Public Production', looked at various tax regimes and which regime would be the most efficient for production. In fact, this paper was one of the reasons that Mirrlees got the Nobel Prize in 1996.

In the 1970s, Diamond turned his attention to social security issues and pension reform, an issue that he continued to work on till much later. He also served on a government panel on the topic. His best-known book on the subject is a 2005 book, 'Saving Social Security: A Balanced Approach', which he co-authored with Peter Orszag, the Obama administration's first director of the Office of Management and Budget. According to Diamond, continued social security in the US would require higher taxes and a reduction in some of the benefits if it had to be continued in the long run. His other works on social security include 'Social Security Reform' (Oxford University Press) and 'Taxation, Incomplete Markets and Social Security' (MIT Press).

On 'search theory', for which he was awarded the Nobel prize, his argument was that buyers and sellers can't find each other seamlessly without incurring some costs. In other words, there is friction in markets, which prevents this from happening. This was, of course, contrary to the neoclassical model where buyers and sellers have full information and find each other simultaneously, without incurring any costs. In his 1971 paper, he showed that when search costs are taken into account by the buyer and seller, the resulting price would be the same as the price that a monopolist would set in the same market. This finding became known as the 'Diamond paradox'.

Main works of Mortensen

Mortensen and Pissarides applied Diamond's search theory to the labour market. They found that there are rigidities in the labour market such as unemployment benefits that may lead to persisting unemployment and encourage job seekers to look for the best package for a longer time. Mortensen's book 'Wage Dispersion: Why Are Similar Workers Paid Differently' (2003), analyses why wages and salaries differ and found that one main reason for this is the time spent on job search as well as different wage policies.

Mortensen was inspired by the work of economists such as Stigler and Phelps in the 1960s, who were looking at unemployment from an individual's point of view. This approach was called the 'dynamic flows approach', whereby the change in unemployment was a function of the state of business activity. Mortensen contributed his first paper to the Phelps volume, which was a collection of articles in macroeconomics dealing with new ideas on unemployment. The article titled 'A Theory of Wage and Employment Dynamics' dealt with the issue of search frictions in the job market. Continuing with this theme, Mortensen published his next article in 1970 in the 'American Economic Review', which was titled 'Job Search, the Duration of Unemployment, and the Philips curve'. Speaking of his experience with the Phelps volume and the debate surrounding the Philips curve at the time, Mortensen writes in his Nobel lecture:

This was the environment in which I began my research and teaching career. At Northwestern we created an informal reading group in the spring of 1968 focused on the macroeconomic implications of these new ideas circulating in the profession about the labor market. I began to think about how to capture the essential features of a decentralized market with search friction in a formal but simple economic model. Using the labor market as my focus, I came up with the idea of modeling the consequence of search and matching friction as the outcome of a sequence of random meetings between potentially interested parties. After I had written a very long working paper designed to formulate and work out some of my idea, Ned Phelps asked me to present it at a conference he was organizing on the topic. I was fortunate to have this, my first major paper, "A Theory of Wage and Employment Dynamics" published in the collection of papers presented at his conference that became universally known as the "Phelps volume." The Phelps volume, Microeconomic Foundations of Employment and Inflation Theory, was published in 1970. It became a classic. The basic message of the collection was that one could and should consider the dual macroeconomic problems of employment and inflation as the outcomes of individual agents' interaction, in which each behaves in his or her own interests in a market environment characterized by uncertainties and incomplete information. In other words, the authors argued that macroeconomics should be founded on microeconomic principles. In addition to myself and Phelps, the authors included a third Economics Prize winner, Robert Lucas. Although the three of us have not always agreed on the details and have taken different directions in the pursuit of the goal, we have shared a common view that macroeconomics needs a foundation based on equilibrium market analysis. My second paper, "Job Search, the Duration of Unemployment and the Phillips Curve", published in the American Economic Review in 1970 as well, was an attempt to use new ideas about decentralized exchange in a labor market with search friction to provide an interpretation of the empirical Phillips curve. I refer to it here, not because I accomplished that goal. In fact, I regard the paper as a failure in that dimension for several reasons. One of these was the inability to close the model with a convincing theory of agent expectations. Arguably this could have been done by invoking "rational expectations," a concept that had already been introduced by one of my Carnegie Tech professors, John Muth (1960). I did not see its relevance for my work at the time, even though I had participated in a seminar on the subject briefly as a student. The issue was subsequently resolved by later adopting the approach in spite of its drawbacks.

Main works of Pissarides

Pissarides collaborated with Mortensen with most of his work on search frictions and their role in the labour market equilibrium. Pissarides chose to focus on a job 'match', rather than a good wage to explore how the labour market attains equilibrium. The reason Pissarides gave for his focus on a good job match was that each job and each worker had many different features and arriving at the right match is a time-consuming process. To quote him from his Nobel lecture:

The foundation for this idea is that each worker has many distinct features, which make them suitable for different kinds of jobs. Job requirements vary across firms too, and employers are not indifferent about the type of worker that they hire, whatever the wage. The process of matching workers to jobs takes time, irrespective of the wage offered by each job. A process whereby both workers and firms search for each other and jointly either accept or reject the match seemed to be closer to reality. This approach to search has the advantage that it makes unemployment neither "voluntary" nor "involuntary", concepts that caused a lot of confusion and fruitless debate in the literature. Unemployment is instead the outcome of a decentralised equilibrium, which may or may not be optimal. It seemed to me that the two-sided matching view had a better chance of success, both in grounding itself in microeconomic theory and in interpreting the facts about unemployment. It allowed one to study equilibrium models that could incorporate real-world features like differences across workers and jobs, and differences in the institutional structure of labour markets. The step from a theory of search based on the acceptance of a wage offer, and one based on a good match, is small, but has far-reaching implications for the modelling of the labour market. The reason is that in the case of searching for a good match we can bring in the matching function as a description of the choices available to the worker. The matching function captures many features of frictions in labour markets that are not made explicit. It is a black box, as Barbara Petrongolo and I called it in our 2001 survey, in the same sense that the production function is a black box of technology. But it captures the key idea of a good match: it takes time to find a good match, the length of time it takes varies across workers in unpredictable ways, and if there were more job vacancies available, on average workers would find a good job match faster. The same applies to firms looking for workers; the matching function treats workers and firms symmetrically. Importantly, because the matching function was similar to other aggregates.

Pissarides, therefore, used a matching function to arrive at the labour market equilibrium. He also proposed a wage theory based on search theory, in the same manner as Diamond and Mortensen. While Diamond and Mortensen had assumed a fixed number of workers looking for a fixed number of jobs, Pissarides looked at varying workers and jobs.

Conclusion

Search theory proposed by the three laureates was a new way to look at the labour market equilibrium since it challenged the earlier neoclassical framework. In fact, the DMP model (Diamond, Mortensen and Pissarides) taught us to look at issues in labour economics such as unemployment and wages in a new light. The model looked at variables such as labour turnover, rates of job findings, matching functions and wage determination, which earlier models had not done. It was also in the tradition of Phelps' work, which looked at micro issues such as workers' preferences while analysing macro variables such as unemployment and inflation. Search theory has also been applied in a variety of fields such as housing, family economics, public finance and monetary economics.

The writer is an IAS officer, working as Principal Resident Commissioner, Government of West Bengal. Views expressed are personal