ANALYSIS OF NOBEL PRIZE WINNER MODEL FOR ECONOMICS

Nobel Prize for Economics

This year’s Laureate trio has formulated a theoretical framework for search markets.

While Peter Diamond of the Massachusetts Institute of Technology analyzed the foundations of search markets, Dale Mortensen of Northwestern University and Christopher Pissarides of the London School of Economics expanded the theory and applied it to the labor market.

Their models help us understand the ways in which unemployment, job vacancies and wages are affected by regulation and economic policy.

Diamond-Mortensen-Pissarides model

One general conclusion arising from their work is that more generous unemployment benefits by government give rise to higher unemployment and longer search duration of jobs.

Generous unemployment benefits have the effect of raising the individual’s reservation wage (the lowest wage at which he/she would be willing to accept a new job).

The reservation wage is also a declining function of time spent in unemployment.

A high marginal tax rate, on the other hand, creates disincentives to work and earn. Means a person will less likely to work if marginal tax rate are higher.

In general, all else constant, the higher the unemployment rate, the poorer a region, and the longer the duration of search for a job, the individual’s reservation wage will be lower.

Hence, if we define the net benefit (or the economic rent) from a job to be equal to the wages paid minus the reservation wage, net benefits from jobs created in poorer regions will be higher.

Economic benefit = wages – reservation wages

In fact, relatively lower reservation wages in India and other Asian countries such as China and the Philippines (compared to the West) explain why jobs are outsourced (or ‘Bangalored’) from the US and Europe.