‘Markets with search frictions’ theory creators win the Nobel Prize in Economic Science

Published on Oct 11, 2010 - 6:42:33 AM


By: AlphaGalileo Foundation

Oct. 11, 2010 - The Royal Swedish Academy of Sciences has decided to award The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for 2010 jointly to:

* Peter A. Diamond (Massachusetts Institute of Technology, Cambridge, MA, USA)
* Dale T. Mortensen (Northwestern University, Evanston, IL, USA)
* and Christopher A. Pissarides (London School of Economics and Political Science, UK) "for their analysis of markets with search frictions"

This year's Laureates have developed a theory which can be used to answer some of the questions about the labour market. The DMP model “have substantially improved our understanding of markets with search frictions”, especially in areas where goods or services are not standardise, according to the Academy. This theory is also applicable to markets other than the labour market, like housing.

Frictions occur in both sides of the market, and we often see that sellers and buyers have difficulties in finding each other. On the one side we see that there are many unemployed people and on the other a large number of job openings. Employers often struggle to find suitable candidates and these to find available positions. In the same way we see families looking for suitable accommodation and many empty properties that are not sold easily.

“The three Laureates have formulated a theoretical framework for search markets. Peter Diamond has analyzed the foundations of search markets. Dale Mortensen and Christopher Pissarides have expanded the theory and have applied it to the labour market. The Laureates' models help us understand the ways in which unemployment, job vacancies, and wages are affected by regulation and economic policy. This may refer to benefit levels in unemployment insurance or rules in regard to hiring and firing. One conclusion is that more generous unemployment benefits give rise to higher unemployment and longer search times.”

The Academy described the model as an important policy tool that can be used to interpret data and implement better policies regarding unemployment and housing, for example.

During the press conference, Pissarides described that his reaction to the phone call announcing the prize was a “mixture of surprise and happiness and generally satisfaction”. He explained that he started his research at a time when unemployment in Europe was raising and he saw this as a real problem where economics could help.

A model for the labor market:

Several important studies on search and matching markets were published around 1980. Peter Diamond, Dale Mortensen and Christopher Pissarides examined the properties of the various markets. They provided new answers to many unsolved issues and could also pose completely new questions which earlier research had not been able to formulate.

In a number of studies, Dale Mortensen and Christopher Pissarides have systematically developed and applied the theory to examine the labor market – particularly the determinants of unemployment. This has resulted in a model known as the Diamond-Mortensen-Pissarides (DMP) model. Today, the DMP model is the most frequently used tool for analyzing unemployment, wage formation and job vacancies.

The DMP model describes the search activity of the unemployed, the recruiting behavior of firms and wage formation. When a job seeker and an employer find one another, the wage is determined on the basis of the situation on the labor market (the number of unemployed workers and the number of vacancies). The model can thus be used to estimate the effects of different labor-market factors on unemployment, the average duration of spells of unemployment, the number of vacancies and the real wage. Such factors may include the benefit level in unemployment insurance, the real interest rate, the efficiency of employment agencies, hiring and firing costs, etc.

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