The Idea That Won the Nobel Prize in Economics

Harvard economist Edward Glaeser has a nice explainer about the ideas that won the 2010 Nobel Prize in Economics. The award went to three economists -- including one, Peter Diamond, whose nomination to serve on the Federal Reserve board is being "held" by Republican Sen. Richard Shelby -- for their work on "search frictions" in the labor market. In short: Why do employers and employees sometimes have such a hard time hooking up?

Economics 101 has offered a couple answers. Wages are "sticky." You don't see salaries collapse in a recession the same way you see oil prices plummet when demand for energy shrinks. When employers choose not to pay those, higher sticky wages to new workers, many workers get left on the sidelines. Moreover, traditional economists have pointed to the minimum wage and unemployment insurance as examples of government creating artificially high unemployment.

The Nobel award went to economists who looked for more sophisticated ways to explain the search friction phenomenon:

In the late 1970s, Professors Diamond, Mortensen and Pissarides all turned to the public policy implications of search models. In a 1977 article "Unemployment Insurance and Job Search Decisions," Professor Mortensen examined the implication of unemployment benefits for unemployment rates. He concluded that the effects were more ambiguous than previously thought, because workers who aren't currently receiving unemployment insurance benefits will be more likely to take on a low-wage, risky job if they know they can get unemployment insurance if the job doesn't work out.

The core of Professor Diamond's work on search models appeared in a three-year window between 1979 and 1982. His work was distinguished both by elegant modeling -- building the theoretical tools needed to make sense of labor turnover--and important insights. Perhaps the key idea is the "search externality," the idea that each "additional worker makes it easier for vacancies to find workers and harder for other workers to find jobs." In a sense, a flood of unemployed workers can congest the labor market just as a flood of extra drivers can congest a highway. Whenever one worker passes up a job, that worker makes finding a job easier for other workers. This insight led to Professor Diamond's conclusion that higher levels of unemployment insurance could improve the workings of the labor market by making some workers pass up marginal jobs.

Read the full story at Economix.