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Add friction to economic modeling

By Victoria Advocate
Oct. 21, 2010 at 5:21 a.m.


By Ray Perryman

Every year since 1901, in addition to the much-publicized Nobel Peace Prize, Nobel Prizes are awarded for achievements in physics, chemistry, physiology or medicine and literature. Of more recent origin is the award commonly known as the Nobel Memorial Prize in Economic Sciences (more formally known as the Syeriges Riksbank Prize in Economic Sciences). This accolade was established in 1968 in memory of Alfred Nobel, founder of the Nobel Prize. Between 1901 and 2010, the Nobel Prizes and the Prize in Economic Sciences have been awarded 543 times to 817 individuals and 23 organizations. The Prize in Economic Sciences specifically has been awarded 42 times to 67 individuals.

This year, the Prize in Economic Sciences is shared among Peter A. Diamond and Dale T. Mortensen of the United States and Chris A. Pissarides of the UK (by way of Cyprus). The 2010 Laureates contribute greatly to theory related to the process of matching buyers and sellers in economic transactions. Of particular relevance right now is the application to the job market, and the problems with matching potential employees with open positions.

As you may recall, if you ever had an economics class, the supply of and demand for goods and services in a market determine price. At the same time, the price of any good or service will be set by competitive markets at just the right level to ensure production of the right mix of things are produced.

However, there are times when this process doesn't work perfectly. One reason is the role of expectations. In today's job market, for instance, potential workers' willingness to take particular jobs depends in part on their expectations about other offers they might or might not receive. Such things are hard to capture in simple economic models.

The work of these men is thus of notable value because it can be used in answering questions such as "why are so many people unemployed at the same time that there are a large number of job openings?" or "how can economic policy affect unemployment?" In general, it can be said that real-world experiences of finding a job, for example, include certain costs and frictions that are often times not accounted for in general economic models. What these three individuals have done, put simply, is find ways to incorporate real-world frictions into the elegant mathematical models often used to describe market behavior.

Employment is just one example of an area where these models can lead to new insight; the theories are applicable to many more situations covering a wide range of social transactions (they have even been used to describe our choices in marriage). It has been most influential, however, in the study of labor markets. Known as the Diamond-Mortensen-Pissarides (DMP) model, or class of models, it is now the most widely-used analytical tool in that area. Overall, these individuals help us better understand the impact that regulation and economic policy have on unemployment, job vacancies and wages.

In today's economy, such models are particularly important in that they help improve understanding of the proper role of unemployment benefits in setting the path toward future economic prosperity. On the one hand, such payments are expensive and can contribute to future debt loads. However, they also allow job seekers the luxury of a little more time for the search process and, thus, a higher probability of a more productive position. In this way, the future performance of the economy is enhanced.

Through their important work, this year's prize winners in the area of economics have generated a flood of related research, writing and advancement of the field. They have also enhanced our understanding of the functioning of markets and the frictions they include. Given the current state of the labor market, such insight is prize-worthy indeed.

Dr. M. Ray Perryman is President and Chief Executive Officer of The Perryman Group (www.perrymangroup.com). He also serves as Institute Distinguished Professor of Economic Theory and Method at the International Institute for Advanced Studies.

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