Monday, 11 October 2010

2010 Nobel Prize: Diamond, Mortensen, Pissarides

The 2010 Nobel Prize in Economics has been awarded to Peter Diamond (MIT), Dale Mortensen (NWU) and Christopher Pissarides (LSE).

Tyler Cowen has written a good concise summary of each prizewinner's work and contribution (linked above). I promised on twitter earlier today to write a post about the application of their research to the 2008-2010 recession.

First I'll mention Diamond's book on behavioural economics, which is one of the respected texts in the field and which I've been meaning to order for a while. Today I finally got around to it. The introduction, available here, gives a very clear and perceptive abstraction of the key contributions of behavioural economics as currently practised. It can be summarised in three departures from the standard model: bounded rationality, bounded willpower and bounded self-interest.

He (and co-author Hannu Vartainen) also reference the psychological process of decision-making as an important part of behavioural analysis, and identify the problem of welfare criteria in a model without rational choice. The book's main contribution is to apply the behavioural model - previously applied mainly in finance - to other areas of economics: public policy, development, law, health, wages and organisations.

The wages chapter of the book attempts to explain wage rigidity behaviourally. But the work of Diamond, Mortensen and Pissarides on search and matching models - for which the Nobel was awarded - is of a different character.

The three of them have not worked directly together (Mortensen and Pissarides have) but their work shares common features. And there seems to be at least one consistent message from the three.

Diamond's work shows that there are multiple equilibria in a market where the agents have a cost of finding opportunities to trade (in fact, he explores this in one paper by replacing the very idea of a "market" with a collection of agents each carrying out a search process). This clearly applies to labour markets, where employers need to advertise jobs, and workers need to spend time finding and applying for them. One consequence of this work: labour markets, even with flexible wages, can suffer persistent unemployment.

Mortensen - sorry, no link to paper - models the diversity of the skills of workers, showing that this (normally considered a cause of structural unemployment) can contribute to cyclical unemployment in a recession.

Pissarides co-authored the key paper of Mortensen above. And has done important empirical work to measure whether these models are actually right. He summarises the common thread of all three: wage stickiness is not the only explanation of unemployment.

This, however, highlights a common phenomenon in equilibrium systems: failures usually have multiple causes. If something in the system does not work properly, prices, supply or demand will usually adjust to correct it - and the system will return to equilibrium. Only if the price mechanism, or some other aspect of the system, is also not working, will the system remain out of balance.

The insights of these three economists' work help illuminate not just the general causes of unemployment, but the specific causes of the current slowdown. At first glance an explanation might be that search costs are especially high right now - but one would have thought that Internet job searching and mobile phones would have reduced those since the last recession. Could wage stickiness be greater than normal? Yes, probably - because of the near-deflationary environment in the US (Roger Farmer here suggests an effect which may partly counter this, that high inflation is more likely to lead to layoffs. Farmer's recent book explores a specific search/matching model and I will be posting an overdue review of it soon).

But remember, we need more than one cause. And the Mortensen/Pissarides paper suggests the answer: work is now more specialised, and skills less transferable, than in the past. Jobs with easily exchangeable skills are, by their nature, those that can most easily be outsourced to low-wage countries or automated away. So, the evolving nature of rich-country employment towards heterogeneous, IT-reliant, knowledge-rich jobs may have led to higher unemployment levels in and after recessions.

We can look deeper, beyond these two causes, and find that they originate from a common source: the cognitive abilities of agents. Recall Diamond's classification above. Because people do not receive and process information perfectly (bounded rationality), they invest in specialisation and cannot adjust immediately to new jobs. And because they do not know and/or obey their own interests (bounded self-interest), wages do not adjust to compensate.

And this, combined with the evolution of employment in the Western countries - arguably also a cognitive phenomenon - explains the increasingly jobless nature of modern recoveries.

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