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While the Nobel Prize for Economics is a significant recognition, the Royal Swedish Academy of Sciences does not determine who is qualified to serve on the Board of Governors of the Federal Reserve System.
—Richard Shelby, (R-AL)

The Nobel Prize for economics was recently announced. It went to three economists who provided the theoretical foundation for understanding search markets. Each had found themselves fascinated by the difficulty that buyers and suppliers sometimes have in finding one another. Together, they found that search markets belie commonly held beliefs of classical economics. They have search costs. They’re often inefficient. They provide multiple outcomes. They’re messy.

Messy markets dumbfound classical economics. Markets are supposed to provide unique and efficient outcomes. Search markets don’t, but they don’t resist analysis. The recipients, Peter Diamond, Dale Mortenson, and Christopher Pissarides, demonstrated this with the DMP model for unemployment. But the model also demonstrates the importance of regulation and policy to affect market structure and improve outcomes. This is far from a laissez-faire point of view so commonly held. Though the recipients focused their efforts on the labor markets, the common features they identified in search markets provide a metaphor for understanding other conventional economic markets and, perhaps, non-traditional markets: the process of finding a spouse or even the marketplace for ideas – a concept still reeling from the controversial Supreme Court opinion on Citizens United v FEC.

Diamond, Mortenson and Pissarides, articulated a handful of common traits associated with search markets. Search markets are typically associated with non-exchange-based transactions, such as labor markets. Unlike on an exchange, it’s typically difficult to find the right buyers or sellers, so search and matching costs, for example, are associated with high real costs. Movement in the labor market, for example, requires individuals to quit or be fired, search for a job and be evaluated, and question accepting a position on the basis of the difficulty of and compensation for the work.

Search markets are also inefficient and may include several outcomes. Though only one outcome can be the best, these markets do not yield unique and efficient outcomes associated with classical economics. Instead, they can lead to imbalances, such as resource utilization, which can skew either too high or too low.

The activity within a search market also affects the search market. When a job-seeker, for example, increases their search activity, the overall market becomes more challenging for other job-seekers and easier for recruiting firms. These are called external effects and are not taken into consideration among market participants. It yielded a relationship between job creation and the intensity of workers seeking jobs. If workers increase the intensity with which they look for jobs, the marginal improvement in a company’s ability to fill a position will encourage employers to open searches for more jobs. It also explains why job openings have increased recently, but the unemployment rate has not changed substantially. These may be attributed to structural issues within the labor market, such as uncertainty about regulation and taxes, a reduced ability to sell one’s house and move to where the jobs are, among other reasons. Perhaps we might also see option-taking by employers. For example, many people are looking for work with intensity, firms can easily fill positions. With low search costs, posting additional vacancies allows them an inexpensive option to hire, should they find someone.

Diamond, Mortenson, and Pissarides, initially working independently, soon found one another in perhaps an example of their own theory of search markets. The realization of one another’s interests galvanized their efforts, and they organized the Diamond-Mortenson-Pissarides (DMP) model to explain the Beveridge Curve. The Beveridge Curve denotes an empirical pattern of high unemployment and low vacancies or low unemployment and high vacancies. The DMP model broke new ground by providing an explanation for the relationship between the underlying economy, various regulations, and the position on the curve.

Rigidities in the labor market can contribute to unemployment. Participants seek to optimize both compensation and the quality of the work required. One’s inclination to compromise before finding the optimal combination might be determined by jobless benefits, the performance of one’s portfolio, or the condition of the overall economy. Similarly, employers might delay listing vacancies or hiring in general if they find it more difficult to fire employees when they feel necessary. India, for example, maintains a rule pertaining to industrial establishments of 100 workers or more. Rather than require the customary one-month notice on termination, industrial establishments require a three month written notice to employees and prior authorization from the appropriate government authority.

The DMP model, however, does not deny the benefits of regulation. Indeed, some regulations may introduce rigidities that impede the market, but properly applied, they may improve the functioning of the market. Though higher unemployment benefits predictably lead to higher unemployment and a higher search time for the unemployed, the DMP model suggests that it nonetheless has its place. Some job searches are complicated by the rarity of an individual’s skills. Without unemployment benefits, they might not have the time to conduct a thorough search. Circumstances will require that they take a position that does not capitalize on their abilities, and the mismatch between an individual and their job will result in a net loss in welfare for the economy overall. If a skilled machinist has to stock shelves at Walmart, the economy does not benefit from the investment required to cultivate those skills in the first place and may pay a price in a company’s inability to fill a vacancy. Without a proper match, the economy will function below its capacity.

Though the recipients’ work centered on the labor markets, search markets have also been applied to many areas where buyers and sellers find it difficult or expensive to find one another. Among them, the process of finding a suitable spouse, identifying and negotiating with strategic suppliers, used car shopping, and perhaps expert networks. Some of these have been explored, others may benefit from analysis through the lens of a search market. Expert networks, a relatively new phenomenon, connect those in need of expertise with those who have expertise through a costly and fitful process of collecting, profiling and delivering independent consultants, former executives, former government officials, and others for paid phone consultations and other engagements.

The metaphor of the market has even been used to understand the freedom of speech guaranteed by the Constitution. Viewing the marketplace of ideas as a search market might be just the metaphor Stevens was looking for when he dissented to the Supreme Court’s decision in Citizens United vs. FEC earlier this year. Indeed, it’s an elaboration of Professor George Stigler’s precursor to search markets discussed the search costs associated with information in his 1961 paper, The Economics of Information. Perhaps it was what Stevens had been struggling with when he wrote:

All of the majority’s theoretical arguments turn on a proposition with undeniable surface appeal but little grounding in evidence or experience, “that there is no such thing as too much speech,”

The marketplace of ideas is a search market. It’s messy. It yields multiple and inefficient outcomes. The Nobel Committee’s reward of Diamond, Mortenson, and Pissarides’ work on Monday helped us understand that better and laid bare the insufficiency of the laissez-faire perspective so often taken.