Search Theory and Labor Markets (60 points).
The 2010 Nobel Prize in
Economics was awarded to Peter Diamond, Dale Mortensen, and Christopher Pissarides
for their development (during the 1970s and 1980s) of search theory.
Search theory is a
framework especially suited for studying labor market issues.
The search framework
builds on, but is richer than, the basic theory of supply and demand.
Search theory can be
applied to both the supply side of the labor market (building on the analysis of Chapter 2)
as well as the demand side of the labor market (building on the analysis of Chapter 6).
what follows, you will study the application of search theory to the demand side of the
There are three basic ideas underlying search theory.
First, search theory incorporates
into basic supply-and-demand analysis the fact that when a firm wants to hire a worker
(i.e., “demands labor”), there is a chance that a suitable worker may not be found.
is, a firm “searching” for a worker has a
probability less than one
that a suitable
“match” will be found.
Second, search theory makes explicit the
costs associated with search activity.
realistic, when a firm wants to hire a worker, it does not simply “go to the market” as in
basic supply-and-demand analysis.
Rather, it must expend resources
worker (think of these costs as the recruiting costs inherent in running a firm’s human
resources department, placing job advertisements in various outlets, the interviewing
Moreover, because of the various activities involved in the search, or
“recruiting,” process, there is a time delay between when a firm engages in recruiting
activities and when, if recruiting is successful, a new employee actually begins working
at the firm.
For concreteness, suppose that if a firm successfully recruited a new