Barbara Petrongolo outlines how his analysis of markets with search frictions has enhanced our understanding of how labour markets work and how policy-makers should respond

Barbara Petrongolo

English

Research Papers in Economics

CentrePiece Winter 2010/11
18
Chris Pissarides,
Nobel laureate
Most market transactions are characterised by various
forms of imperfections or ‘frictions’. The importance of
these frictions in driving market outcomes is a key issue
for understanding such diverse markets as those for a job,
a house and a spouse.
While a given market may have buyers and sellers who
can in principle agree on a price, this may be insufficient
for immediate trade to take place. Both buyers and sellers
may need to invest in a costly and time-consuming
process of search to locate and assess matching partners,
and they eventually need to agree to enter a transaction
rather than wait for better trading opportunities.
Search theory – for which Chris Pissarides, Dale Mortensen
and Peter Diamond have been honoured with the 2010
Nobel Prize in Economics – provides a versatile framework
for understanding market outcomes in a variety of
situations in which trade is complex. One key lesson of the
theory is that with search frictions, not all markets will
clear at all points in time – some buyers and/or sellers
remain unmatched.
Another important implication of search theory is that
when access to information is costly and trade
opportunities are infrequent, not all traders may trade at
the same market price, leading to dispersion in prices.
Finally, market outcomes may be inefficient if individuals
engage in ‘too much’ or ‘too little’ search, in which case
policy intervention may improve on what can be achieved
through markets alone.
Although economists have long been aware of the
importance of frictions (see, for example, Hicks, 1932),
these frictions were not brought into formal models until
the work of the three Nobel laureates and a few other
researchers in the 1970s. Since then, they have generated
an incredibly large and ever growing literature, addressing
the role of frictions in many ‘real world’ markets.
In the labour market, frictions are used to explain the
existence of unemployment and wage inequality. In
business cycle models, they are used to explain the
amplification of the response of employment to
aggregate shocks. In monetary models, they are used to
explain the existence of money. In the housing market,
they are used to explain residential choices and
fluctuations in house prices. And in the marriage market,
they are used to explain dating, marriage, fertility and
divorce behaviour. 
By far the most influential application of search theory
has been to the labour market, and it has led to the
development of what is now recognised as the leading
model of ‘equilibrium unemployment’. This is the area in
which Chris Pissarides, former director of CEP’s
macroeconomics programme, made his main
contributions to search theory. His seminal work on the
functioning of labour markets with frictions appeared in a
number of articles in the late 1970s and 1980s, and was
later organised in a unified framework in a book that has
become a key reference in modern labour market analysis
(Pissarides, 1990).
The central idea is that trade in the labour market is
uncoordinated, time-consuming and costly for both firms
and workers. Workers need to spend time and resources
to find suitable job opportunities; and firms need to
spend time and resources to locate and screen job
applicants. While the idea that trade in the labour market
is complex is widely accepted these days, when search
models of unemployment were first developed, they
The 2010 Nobel Prize in Economics was
awarded to CEP’s Chris Pissarides,
jointly with Peter Diamond and Dale
Mortensen,‘for their analysis of markets
with search frictions’.As Barbara
Petrongolo explains, their research has
deeply enhanced our understanding of  
how labour markets work and how
policy-makers should respond.CentrePiece Winter 2010/11
19
implied a clear break with the perfectly competitive view
of equilibrium in the labour market, which hinges on
frictionless trade. 
In a perfectly competitive labour market firms and
workers meet costlessly and trade at a single wage, and
any excess labour supply is absorbed instantaneously
through a fall in the equilibrium wage. Most economists
would argue that the functioning of the labour market is
far more complex than this. In particular, the competitive
model fails to explain such stylised facts as persistent
unemployment, wage differentials among otherwise
similar workers and the co-existence of unemployed
workers and job vacancies.
By introducing realistic frictions, the search approach has
developed an elegant framework that allows us to
explain key stylised facts about the labour market and
ultimately think about unemployment and wages in a
new light. For example, a direct consequence of frictions
is that as markets typically do not clear, unemployed
workers and job vacancies may co-exist, even within very
narrowly defined labour market segments.
In particular, unemployment persists in equilibrium
because before all unemployed workers find new jobs,
some of the existing jobs come to an end, providing a
new inflow into unemployment. This suggests that after
an adverse economic shock, it takes time to bring back
unemployment to the pre-shock level. So recovery after a
recession may be slow, even once new job opportunities
start to emerge. 
An important implication of job search frictions is that
existing jobs produce ‘rents’. This means that if an
employer and a worker are separated for reasons outside
their control, at least one (and often both) of them is
worse off. Rents give employers some degree of market
power over their employees, which means that unlike in
the perfectly competitive model, small wage cuts do not
induce all employees to quit their jobs, simply because
better paid jobs elsewhere in the economy are hard to
find. As a corollary, workers of similar quality may be paid
different wages if employed in different firms.
Search models have also been used to understand how
aggregate shocks are transmitted to the labour market
via the response of job creation and job destruction, and
how shocks drive cyclical fluctuations in unemployment.
Chris Pissarides has made the two key contributions in
this area.
The first is his seminal search-theoretic analysis of the
dynamics of unemployment, vacancies and real wages
(Pissarides, 1985), which illustrates the asymmetric
behaviour of unemployment following positive and
negative shocks. He shows that the rise in unemployment
in a recession will be faster than its fall in an
expansionary phase, because while an adverse shock
results in an immediate increase in job separations, a
positive shock only leads to a gradual fall in
unemployment because the hiring process is time-
consuming.
The second key contribution is his most famous article,
written jointly with Dale Mortensen (Mortensen and
Pissarides, 1994). This work illustrates how firms respond
to shocks to aggregate productivity in making their
decisions about creating new jobs and ending existing job
matches – and thus produce cyclical fluctuations in job
flows and unemployment.
The core theoretical work on labour markets with search
frictions has been accompanied by a number of
contributions focusing on policy analysis and empirical
evidence. It has become common practice in the
literature to adopt a search framework to analyse the
impact of unemployment compensation, hiring and firing
costs, minimum wages, and taxes on unemployment and
the wage distribution. Empirical work has addressed the
implications of search models for individual labour market
transitions, aggregate job and worker flows,
unemployment dynamics and the wage distribution. 
The work of Chris Pissarides and his fellow Nobel
laureates has deeply influenced the view of modern labour
markets of both academics and policy-makers and has
stimulated several continuing streams of work at CEP. 
As many countries are facing the consequences of the
most severe recession of the post-war era, the latest 
Nobel Prize is an award to research on fundamental
economic issues that are both at the core of the wellbeing
of society at large and very high on the policy agenda of
the moment.
Barbara Petrongolo is a professor of economics at Queen
Mary, University of London, and a research associate in 
CEP’s labour markets programme.
Further reading
John Hicks (1932) The Theory of Wages, Macmillan
Dale Mortensen and Chris Pissarides (1994) ‘Job Creation and
Job Destruction in the Theory of Unemployment’, Review of
Economic Studies 61: 397-415
Chris Pissarides (1985) ‘Short-run Equilibrium Dynamics of
Unemployment,Vacancies, and Real Wages’, American
Economic Review 75: 676-90
Chris Pissarides (1990) Equilibrium Unemployment 
Theory, Blackwell

Chris Pissarides, CEP's Nobel laureate

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Chris Pissarides, CEP's Nobel laureate

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