Nobel Prize in Economics: 2010

Commentary

by Professor Richard McIntyre, Ph.D.

Professor of Economics

Diamond, Mortenson and Pissariades were awarded the Nobel prize in Economics this year for “search theory.” This work was part of the increased interest in the costs of information in the 1970s. It was also one of a number of approaches that shifted attention from the demand to the supply side of the labor market at that time. Search theory has applications to housing and public economics but I will confine my comments here to the labor market implications of search theory.

The idea that workers and jobs are heterogeneous and that it takes time and effort to match them is useful for both policy and theory. Sweden’s “active labor market policy” sought to reduce frictional unemployment even before the now classic papers on search theory were published. Perhaps this is why the Swedish Central Bank made this award, although speculation about the reasoning behind these awards is not terribly productive in my opinion.

One interpretation of search is that it explains the persistence of high unemployment rates. In the New York Times article announcing the award Robert Shimer, an economist at the University of Chicago, was quoted as saying that “That’s a big controversy in the U.S. recently. Most of these models suggest that even in a depressed economy, more generous unemployment benefits tend to raise the unemployment rate. Benefits are obviously good for the unemployed, but there are some clear tradeoffs.”

Standard labor market models assume that workers make choices whether to work or not based on their reservation wage and the level of unemployment benefits. But in the current situation, there are so few jobs available that workers are more likely to drop out of the labor market than to be re-employed. Those who have maintained employment are more likely to be involuntarily working part time because of slack demand. So far this is the weakest recovery since World War II. In other words the high rate of unemployment is overwhelmingly due to slack demand rather than longer search periods caused by extended unemployment benefits. Since only about 40 percent of the unemployed generally receive benefits, while there may be anecdotes about people remaining unemployed so as to collect benefits, this is a minor part of the current labor market story.
There is an older view associated with Frances Perkins and other architects of the New Deal in which unemployment and low wages lead to more unemployment. As people lose their jobs and/or wages fell, more people in the family had to seek work, thus increasing the excess supply of workers relative to available jobs. By this logic larger/longer unemployment insurance lowers unemployment by reducing the number of people who have to go job-hunting when employment opportunities are scarce.

Unemployment in Europe has generally been higher than in the US over the last two decades and some economists try to use search theory to explain this. Here is Lawrence Katz of Harvard from the same Times article: “Many European countries put restrictions on the ability of firms to hire and fire. If you make it harder to hire and fire, then you end up with what’s called a sclerotic labor market, with less movement between jobs and more long-term unemployment.”
There is a basic empirical problem here also. European labor markets were much more rigid in the 1960s and 70s than they are today, and yet unemployment rates at that time were significantly lower in Europe than in the United States.

Reactionary attempts to build on this year’s Nobel then are strained at best. The winners of this year’s prize do not draw these kinds of conclusions. Diamond has argued that current labor market problems are primarily due to lack of aggregate demand and that loss of skills by those who have dropped out of the labor market is a bigger problem than the disincentive effects of unemployment compensation. Mortenson has said that credit market and not labor market problems are the real issue that we face.

These divergent conclusions point to both a strength and weakness of orthodox economics. The scientific apparatus of contemporary economics can be used to justify a wide range of policies. But that very range causes people to question the scientific nature of economics itself.  
More important is what search theorists don’t do. As Marx and others have pointed out, it is in the labor process, not the labor exchange that exploitation occurs. And here employers clearly have the upper hand. Further, many labor market and labor process outcomes – employment, remuneration, working conditions, training – reflect what employers choose to do, except perhaps during short-lived moments of full employment. Since the 1970s, in the US at least, the rhetoric of labor economics has been mainly about workers rather than employers, and mostly focused on what workers should do to make their labor time more salable. At best search theory tells us that people are doing something useful while they are unemployed. But for the most part it distracts us from that fact that employers have the upper hand in the labor market and that there is no such thing as democracy inside the firm, where Americans spend most of their waking time.