As the world struggles to recover from the financial crisis, the Nobel prize for economics has been awarded to three researchers whose work explains how market frictions can hinder the smooth functioning of the economy and its ability to adjust to shocks.
Peter Diamond, one of the laureates, is a nominee for the board of the Federal Reserve. His original nomination by president Barack Obama was endorsed by the Senate’s banking committee, but returned to the White House after the full Senate failed to keep the nomination alive over the summer recess.
Mr Diamond and his fellow laureates – Dale Mortenson and Christopher Pissarides – have made fundamental contributions to understanding how supply and demand are matched when there are transactions or search costs involved. “
During Senate committee hearings in July, Republican Senator Richard Shelby questioned Mr Diamond’s qualifications to make decisions on monetary policy, saying “the current environment of uncertainty would not benefit from monetary policy decisions made by board members learning on the job”.
The laureates “search and matching” theories show that it is not enough to have buyers and sellers who can in principle agree on a price; those buyers and sellers must also find each other and decide to enter into a transaction rather than hold out for a better match.
Transactions do not happen by themselves but after a search process that can be costly and time-consuming, the research found. This makes it possible for market outcomes to match supply and demand well, inefficiently or not at all.
The laureates’ insights have been applied, by themselves and many other researchers, to a wide range of markets, including the housing market, financial products and even marriage choices. But the most important application has been labour markets.
Frictions in the matching of workers and jobs mean that labour market outcomes can be inefficient. In particular, the market may produce outcomes in which unemployment persists even if there are workers who would be willing to work at a wage employers would be willing to pay.
This research has helped sharpen economists’ analysis of the causes of unemployment and of the effectiveness of government policies to bring it down. The enduring relevance of the laureates’ work is borne out by the stubbornly high unemployment rates in the aftermath of the financial crisis. In the US, for example, many unemployed used to work in construction, which collapsed with the housing bubble. Search and matching costs are important factors in how fast they will find jobs in other sectors.
Mr Diamond and Mr Mortenson teach at the Massachusetts Institute of Technology and at Northwestern University, respectively. Mr Pissarides works at the London School of Economics and Political Science
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