If you have ever tried to find a job, or to buy or rent a house, you will know that such undertakings are not without their ‘inefficiencies’, or, as economists like to term them, their frictions. The same goes for those trying to fill jobs, or sell homes: although the perfect employee or buyer might be out there somewhere, the job and property markets unfortunately do not work with such efficiency that you can locate them immediately, or indeed at all. Unlike the perfectly-functioning systems envisaged in early models of the labour and housing markets, searching and finding, in our sometimes too real world, comes at a cost.
It is for finding ways to incorporate these real-world frictions into the mathematical models that describe market behaviour that Peter Diamond, Dale Mortensen and Christopher Pissarides have been awarded the 2010 Prize in Economic Sciences. Such models provide tools with which to study and dissect the way that markets work, and their use is providing new insights into the way that policy should be implemented. Applicable to almost any situation that depends on the formation of mutually beneficial relationships over time, the models cover a wide range of social transactions, from employment to marriage.
In the early 1970s, Peter Diamond sought to model the ways that frictions in economic transactions affected pricing, reaching the surprising conclusion, known as the Diamond Paradox, that small frictions generate large deviations from competitive equilibrium. This study served to highlight the importance for model-building of considering the environment under which people search for commodities within a market, and then forge agreements once a match is found. During the following decade, Diamond, in parallel with Mortensen and Pissarides, extended the inclusion of search and matching environments into economic models, the resulting work falling under the broad banner of ‘search and matching theory’.
The area in which this work has been most influential is in the study of labour markets, where the so-called Diamond-Mortensen-Pissarides (DMP) model, or class of models, is now the most widely-used analytical tool.