INFORMATION FOR THE PUBLIC
Markets with search costs
Why are so many people unemployed at the same time that there are a large number of job openings? How can economic policy affect unemployment? This year’s Laureates have developed a theory which can be used to answer these questions. This theory is also applicable to markets other than thelabor market. According to a classical view of the market, buyers and sellers find one another immediately, without cost, and have perfect information about the prices of all goods and services. Prices are determined so that supply equals demand; there are no supply or demand surpluses and all resources are fully utilized. But this is not what happens in the real world. High costs are oftenassociated with buyers’ difficulties in finding sellers, and vice versa. Even after they have located one another, the goods in question might not correspond to the buyers’ requirements. A buyer might regard a seller’s price as too high, or a seller might consider a buyer’s bid to be too low. Then no transaction will take place and both parties will continue to search elsewhere. In other words, theprocess of finding the right outcome is not without frictions. Such is the case, for example, on the labor market and the housing market, where searching and finding are essential features and where trade is characterized by pairwise matching of buyers and sellers. This year’s Laureates have enhanced our understanding of search markets. Peter Diamond has made significant contributions to the fundamentaltheory of such markets, while Dale Mortensen and Christopher Pissarides have further developed search theory and made it applicable to analysis of the labor market. The three laureates’ achievements help us to comprehend a number of important economic questions in general, and the determinants and development of unemployment in particular. The basic idea in search theory is that participants in amarket look for cooperative partners in order to implement joint projects. This may involve simple cases of a buyer and a seller of a product, as well as more complex relations between employers and job seekers or between firms and their suppliers. As usual in the case of basic research, there are many conceivable areas of application. The housing market, for instance, is a clear-cut parallel tothe labor market in that both the number of vacancies and the time it takes to sell a home vary over time. Search theory has also been used to study issues in monetary theory, public economics, regional economics and family economics.
The Theory Takes Shape
In the 1960s, researchers had already begun to use mathematical models to study the best possible way in which a buyer can try to find anacceptable price. In a renowned article from 1971, Peter Diamond examined how prices are formed on a market where buyers look for the best possible price and sellers simultaneously set their best price while taking buyers’ search behavior into account. Even small search costs turned out to generate a radically different outcome compared to the classical competitive equilibrium. In fact,equilibrium prices are equal to the price which a monopolist would have set on a corresponding market without search costs. This result attracted considerable attention and initiated intensive research on search markets. 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. Two key insights emerged from this work. First, a search market is characterized by so-called external effects which are not taken into consideration by individual agents. If someone who is unemployed increases his, or her, search activity, it...