Thursday, October 28, 2010

Nobel Prize in Economics for Unemployment

My latest piece is about the recently announced Nobel Prize in Economics. I briefly discuss some of the main points of MDP’s research and its implications in real life. For more discussion about the trio’s work, reaction from other economists, Diamond Paradox, and, following their work’s trail, the rationale for “aggregate demand management”, see this blog post.

Nobel for unemployment

The Nobel Prize in economics is probably one of the most eagerly awaited prizes. Officially known as Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, this year’s laureates are Peter Diamond, Dale Mortensen and Christopher Pissarides. They were given the prize for “their analysis of markets with search frictions.” It is basically a Nobel for unemployment! Apart from labor markets, their work is also used to analyze and fathom a variety of fascinating economic and social issues.

Given the tumultuous global economy and faltering recovery, many predicted that this year’s prize would go to some scholars who had done work related to recession and recovery. Economists like Alberto Alesina, Nobuhiro Kiyotaki, John Moore, and Kevin Murphy were high on the list of Thomson Retuers, which regularly predicts scholars who might win the Nobel Prize. Additionally, economics blogs were flooded with names of Robert Barro, Wiliam Nordhaus, Martin Weitzman, Robert Shiller, and Eugene Fama. However, like in the previous years, the Nobel committee surprised most of the economists and analysts by awarding the coveted prize to economists who had done seminal work not on the causes and making of recession, but on one of the outcomes of recession, i.e. unemployment.

The trio showed that an unregulated market does not clear by itself, as has been asserted by classical economists. The classical economists believe that markets always clear because prices are determined in such a way that demand matches supply (they assume perfect information and no transaction costs). In reality, it is not so. The trio’s work shows that even if there are jobs available in an economy, employers might not be able to find suitable workers, and vice versa.

In reality, buyers and sellers face costs in their attempts to locate each other (“search”) and meet pair-wise when they come into contact (“matching”). A small search cost could drastically change the outcome, which is not factored in the classical labor market models. Search cost moves equilibrium price away from competitive price. Aggregate welfare is not necessarily higher with more searches since searches itself are costly. Resource utilization could be either low or high as the search and matching process involves costs. There could be too little or too much searches.

Simply, buyers are unable to find perfect sellers, or vice versa, all the time. Even if they did, there might be disagreements in the prices. This means that both buyers and sellers will continue searching for deals until a settlement is reached for a cooperative transaction that satisfies both of their aspirations. This process of finding the desired outcome is not frictionless. Though this might sound intuitive, the trio clarified this feature of the labor market by using economic models and by applying that to real life. Their work helped economists and policymakers comprehend how unemployment works and persists in an economy and what can be done about it.

One important implication of their research is that an external agent could intervene in a market and provide lubrication to reduce friction that emerges in transaction between sellers and buyers. When unemployment is high despite the availability of jobs, the government can facilitate the process of matching workers and employers, thus reducing search costs incurred by both the agents. Furthermore, the government can roll out training programs to upgrade skills of workers so that their skills are compatible to requirements of employers. In the absence of such a lubricating force, the continuous search and matching environment can lead to macroeconomic unemployment problems as coordinating trade does not match one-to-one. This provides a rationale for “aggregate demand management” to steer the economy towards the best equilibrium by reducing coordination failures.

Their work has been used to analyze various issues in real life. For instance, it is used to examine the effect of policies concerning hiring and firing costs, minimum wage laws, taxes, and unemployment benefits on unemployment and economic welfare. It is also used to explain dating, marriage, fertility, and divorce behavior. It has been used to explain why women tend to prefer older men for marriage more in developing countries than in developed countries (Hint: Social norms matter and wages tend to increase with age!).

More relevant to this discussion is the following realistic situation: There are numerous men and women looking for partners in the marriage market. However, not everyone is successful, leading to gradual development of anxiety and frustration. The search, which involves cost, by agents willing to marry might not lead to a satisfactory equilibrium. The search costs of finding perfect match might increase with time. Had there been perfect information about everybody looking for a partner in the marriage market, there would have been equilibrium, i.e. everyone would find a suitable, or at least satisfactory, partner. However, we live in an imperfect world where there are information asymmetries and coordination failures. So, sometimes the search continues endlessly and frustratingly for extremely eligible bachelors.

What could be the solution? One idea coming out of the work of the Nobel laureates is to reduce search costs by facilitating the matching process. Since the agents searching for partners are unable individually to strike a cooperative deal, the market should be intervened or facilitated by external agents. This could come in different forms. For instance, relatives could intensify their search and lubricate friction in search process. Another increasingly popular idea could be facilitation of matching process online through matching portals. This helps to clear the marriage market to some extent by reducing search time and friction, and facilitating meaningful deliberations between willing agents in the marriage market.

This is one of the many applications of the work pioneered by Diamond, Mortensen and Pissarides. Their fundamental work had been in analyzing search frictions and its impact on unemployment. This year’s economics Nobel is a prize for unemployment!

[Published in Republica daily, October 26, 2010, pp.7]