Nobel Prize in Economics 2010: Search Frictions and the Dmp Labour Market Model

This note covers the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2010, widely called the Nobel Prize in Economics 2010: who won it, what "search frictions" means and why markets with search costs do not behave like the textbook model of perfect competition, how Peter Diamond's work on prices, and Dale Mortensen and Christopher Pissarides's work on unemployment, built the Diamond-Mortensen-Pissarides model of the labour market, how the discovery unfolded across four decades, why it still matters for job policy, and a quick-facts summary for exams.

What was the Prize in Economic Sciences 2010 awarded for?

The Royal Swedish Academy of Sciences gave the 2010 prize jointly to Peter A. Diamond, Dale T. Mortensen and Christopher A. Pissarides "for their analysis of markets with search frictions". That is the official citation, and it is worth reading slowly because every word carries weight.

In plain language: in most real markets, a buyer and a seller do not meet instantly and trade at one fixed price, the way simple textbook diagrams suggest. Finding the right partner takes time, effort and sometimes money.

Economists call this cost of finding a trading partner a search friction. The three laureates built the theory that explains how prices, wages and the number of unsold goods or unfilled jobs are decided once you take this friction seriously, especially in the labour market, where it explains why unemployed workers and unfilled vacancies can exist side by side.

The prize's official name is the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, announced on 11 October 2010 and worth 10,000,000 Swedish kronor, split equally three ways.

Who are the laureates?

Peter A. Diamond

Peter A. Diamond was born on 29 April 1940 in New York, NY, USA. At the time of the award he was at the Massachusetts Institute of Technology (MIT), Cambridge, MA, USA, where he received his PhD in 1963 and had served on the faculty since 1966.

He received one third of the prize. Diamond's central contribution was to work out the basic logic of search markets: how prices form when buyers and sellers have to search for each other, and how efficient, or inefficient, the resulting outcome is.

His 1971 paper on price adjustment produced the surprising result now called the Diamond paradox, and his later work showed how search frictions could cause whole economies to settle into either a good or a bad pattern of activity.

Dale T. Mortensen

Dale T. Mortensen was born on 2 February 1939 in Enterprise, OR, USA, and died on 9 January 2014 in Wilmette, IL, USA. At the time of the award he held the Ida C.

Cook Professorship of Economics at Northwestern University, Evanston, IL, USA, and also held a Niels Bohr Visiting Professorship in Economics at Aarhus University, Denmark. He received one third of the prize.

Mortensen's early papers on job search, from around 1970, started the whole research programme, and he later worked with Pissarides to turn search theory into a full model of unemployment, job vacancies and wages.

Christopher A. Pissarides

Christopher A. Pissarides was born on 20 February 1948 in Nicosia, Cyprus. At the time of the award he was Professor of Economics and held the Norman Sosnow Chair at the London School of Economics and Political Science, London, United Kingdom.

He received one third of the prize. Pissarides built the dynamic model, published mainly in 1985, that linked search behaviour to unemployment, vacancies and real wages over time, and he worked with Mortensen on the model that now carries all three laureates' names, the Diamond-Mortensen-Pissarides model.

What problem does search theory answer?

Before this line of research, the standard picture of a market assumed that buyers and sellers find each other instantly and at no cost, and that both sides have complete information about every price on offer.

Prices then settle wherever supply equals demand, and there is no reason for unsold goods or idle buyers to exist for long.

That picture does not match the labour market. Employers looking for staff and workers looking for jobs almost never meet immediately. A worker may not know which firms have openings; a firm may not know which applicants are suitable.

Reaching an employer or a candidate, checking whether the match is a good one, and agreeing terms all take time and resources.

The press release put the puzzle this way: "Why are so many people unemployed at the same time that there are a large number of job openings?"

This is not only a labour-market question. The same mismatch shows up whenever buyers and sellers must locate one another one pair at a time: houses for sale sitting on the market while buyers keep looking, or firms searching for suppliers.

Before Diamond, Mortensen and Pissarides, economists had tools for markets that clear instantly, but no rigorous, widely usable theory for markets where search itself is costly and matching happens one pair at a time. Their joint work filled that gap.

How does Diamond's price model explain the "Diamond paradox"?

Diamond's starting question was simple: if buyers have to spend time and effort searching for a good price, what prices will sellers actually charge? His 1971 paper, "A Model of Price Adjustment", worked through a market where many identical sellers each commit to a price in advance, and buyers search sequentially, learning one seller's price at a time, at a fixed search cost each time they look again.

The result surprised economists. One might expect that search costs would simply spread prices out, since some buyers settle for a slightly higher price rather than keep searching.

Instead, Diamond showed that even a tiny search cost is enough to push every seller to charge the single highest price that buyers are willing to pay, the same price a monopolist would set. This became known as the Diamond paradox.

1. Every buyer knows the overall spread of prices in the market but learns only one seller's actual price at a time.
2. A buyer decides, after seeing a price, whether to accept it or pay the search cost to look at one more seller.
3. Because all buyers face the same cost and the same price spread, they all end up with the same cut-off price above which they would rather keep searching.
4. If there were no spread in prices, no buyer would ever bother to search again, so each seller can safely raise its price right up to that shared cut-off, which is the highest price buyers will still accept.

The outcome is a single price for everyone, not a competitive price. This mattered because it showed that search frictions, even very small ones, can move markets far away from the textbook competitive outcome, triggering decades of follow-up research into why real prices and wages are often spread out rather than identical.

Why don't search markets reach an efficient outcome by themselves?

A second major strand of the work asked whether search markets, left alone, deliver the best possible outcome for society.

Diamond, Mortensen and Pissarides, working mostly in the late 1970s and early 1980s, showed that the answer is usually no, because search creates effects on other people that an individual job seeker or firm does not take into account.

Consider one unemployed worker who searches harder for a job. This has two opposite effects on others.

It makes it harder for other job seekers to find work, because they are now competing with a more active searcher; this is called a congestion externality.

At the same time, it makes it easier for firms to fill vacancies, because there is now a more active pool of candidates; this is called a thick-market externality.

Since the individual worker ignores both effects on everyone else, the overall amount of searching in the economy, and hence the unemployment rate, is generally not the socially best amount.

Diamond went further in a highly influential 1982 paper, showing that this kind of search market can settle into more than one stable pattern of activity: a version with low production and little trade, or a version with high production and brisk trade, both consistent with the same underlying rules.

The Academy noted that this gives a reason for "aggregate demand management", steering the economy toward the better of the possible outcomes.

This was presented as a modern, careful way of examining ideas close to those in Keynes's business-cycle theory, where swings in confidence can push an economy between good and bad states.

How does the Diamond-Mortensen-Pissarides (DMP) model explain unemployment and the Beveridge curve?

Mortensen and Pissarides turned these ideas into a working model of the whole labour market, developed mainly through the 1980s and brought to its now-standard form in work including Pissarides's 1985 paper and the joint Mortensen and Pissarides paper of 1994.

This is the Diamond-Mortensen-Pissarides (DMP) model, described by the Academy as the most frequently used tool for analysing unemployment, wage formation and vacancies.

The model treats the labour market as a continuing flow, not a one-off snapshot. Jobs are destroyed at some steady rate, sending workers back into unemployment, while unemployed workers and open vacancies are brought together by a matching function, which turns the stock of job seekers and the stock of vacancies into a flow of new hires. The model works through the following logic.

1. Unemployed workers and firms with vacancies meet through the matching function; a tighter labour market (relatively more vacancies than job seekers) means workers find jobs faster but firms fill vacancies more slowly.
2. When a worker and a firm meet, they decide whether the match is worth forming, given the value of staying unemployed or leaving the vacancy open instead.
3. If they match, the wage is set by bargaining between the two sides, splitting the gains from the match according to each side's bargaining strength; this bargained wage depends on productivity, on unemployment benefits and on how tight the labour market is.
4. Firms only open new vacancies as long as doing so is still profitable, which pins down how many vacancies exist in equilibrium, given hiring costs and the chance of filling a post.
5. Existing jobs end at some rate, whether through firms cutting positions or workers leaving, returning workers to the unemployment pool and restarting the cycle.

One well-known pattern that the model explains is the Beveridge curve, named after the British economist William Beveridge, which shows that periods of high unemployment tend to go with few vacancies, and periods of low unemployment tend to go with many vacancies, tracing out a downward-sloping curve.

The scientific background paper illustrated this using United States data on unemployment and vacancies from 2000 to 2010.

Draw a graph with the unemployment rate on the horizontal axis and the job-vacancy rate on the vertical axis.

Plot a smooth downward-sloping curve: points with high unemployment sit at the low end of the vacancy axis, and points with low unemployment sit at the high end of the vacancy axis.

Mark that a curve shifting outward (both unemployment and vacancies rising together) signals weaker matching in the labour market, while movement along one fixed curve signals changes in the overall demand for labour.

The model's clean structure also makes it useful for policy questions, including the effect of unemployment benefit levels, hiring and firing costs, and the efficiency of job-matching institutions, on unemployment, vacancies and wages.

How did the discovery unfold?

The theory did not arrive all at once. It grew over roughly four decades, from early studies of how a single job seeker searches, to a full model of the whole labour market.

Why does it matter?

The DMP model has become, in the Academy's own description, the most used framework for studying unemployment, wage setting and vacancies, which makes it a working tool rather than only an academic curiosity.

It lets economists ask precise questions about policy: how generous unemployment benefits, the real interest rate, hiring and firing costs, and the efficiency of employment agencies, each change the unemployment rate, the length of unemployment spells, the number of vacancies and real wages.

One conclusion that the committee highlighted directly is that benefit levels that are more generous than average tend to lengthen job search and raise unemployment, a relationship the scientific background says has also received strong empirical support.

At the same time, unemployment insurance can help match the "right person in the right place", so policy design has to weigh income protection for laid-off workers against this search-slowing effect.

Search theory has travelled well beyond the labour market. The same logic has been applied to the housing market, where the number of homes for sale and the time it takes to sell one both vary, and to questions in monetary theory, public economics, financial economics, regional economics and family economics.

The scientific background notes an open question too: during the crisis conditions of the period studied, the Beveridge curve shifted outward in ways that were, at the time, not yet well understood, showing that search-and-matching theory remains an active area of research rather than a closed chapter.

How does this connect to what you study?

Economics students who learn about demand, supply and market equilibrium usually start with the simple picture of instant, costless trade. This prize is a good example of how real markets, especially the labour market, depart from that simple picture once search and matching costs are taken seriously.

Topics such as unemployment, wages and labour-market policy, which appear in school and college economics courses, rest on ideas this prize helped formalise: that unemployment and vacancies can coexist, that wages are often set through bargaining rather than a single market-clearing price, and that government policy on benefits or hiring rules has measurable, model-based effects on jobs.

Understanding the DMP model gives a deeper, more realistic sense of why labour markets behave the way newspapers and policymakers describe, rather than the way a single supply-and-demand diagram might suggest.

Quick facts for exams

The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2010, commonly called the Nobel Prize in Economics 2010, was awarded jointly to Peter A. Diamond (USA), Dale T. Mortensen (USA) and Christopher A.

Pissarides (Cyprus and United Kingdom), each receiving one third of the prize, "for their analysis of markets with search frictions". The Royal Swedish Academy of Sciences announced the prize on 11 October 2010.

Diamond worked on the foundations of search markets and the Diamond paradox in price formation; Mortensen and Pissarides extended search theory into the Diamond-Mortensen-Pissarides model of unemployment, job vacancies and wages.

The prize amount was 10,000,000 Swedish kronor, shared equally among the three laureates.

Note: Source. The prize facts in this note are from the Nobel Prize's official site, nobelprize.org.

Glossary

• Search friction — the time, effort or money a buyer and seller must spend before they find each other and trade.
• Search cost — the resource cost of looking for another possible trading partner instead of accepting the current offer.
• Diamond paradox — Diamond's 1971 finding that even a tiny search cost can push all sellers to charge the highest price buyers will accept, rather than spreading prices out.
• Matching function — a relationship showing how the number of job seekers and vacancies together determine the flow of new hires.
• Congestion externality — the effect by which one job seeker searching harder makes it harder for other job seekers to find work.
• Thick-market externality — the effect by which one job seeker searching harder makes it easier for firms to fill vacancies.
• Beveridge curve — the downward-sloping relationship between the unemployment rate and the job-vacancy rate, named after William Beveridge.
• DMP model — the Diamond-Mortensen-Pissarides model, the standard framework combining search, matching, wage bargaining and job creation to explain unemployment.
• Wage bargaining — the process by which a worker and a firm, once matched, split the gains from the job between wages and profit.
• Free entry of vacancies — the assumption that firms keep opening job vacancies only as long as doing so remains profitable.
• Labour market tightness — the ratio of vacancies to unemployed job seekers, which affects how quickly each side finds a match.
• Coordination failure — a situation where an economy settles into a worse outcome than it could reach, because individuals cannot coordinate their choices.
• Constrained efficiency — the best outcome achievable given that search frictions themselves cannot be removed from the economy.

Common errors and misconceptions

• Misconception: Search frictions only matter for low-skill or informal jobs. Correct: The theory applies across the whole labour market, and also to housing and other matching markets, regardless of skill level.
• Misconception: The Diamond paradox predicts that prices will be very spread out because of search costs. Correct: Diamond actually showed the opposite, that small search costs can collapse prices to a single, high monopoly-like level.
• Misconception: Unemployment exists only because of a lack of demand for workers. Correct: The DMP model shows unemployment and vacancies can coexist even in a steady state, because matching itself takes time, separate from any shortfall in demand.
• Misconception: More generous unemployment benefits always help workers with no downside. Correct: The theory and supporting studies show more generous benefits tend to increase both the unemployment rate and the length of unemployment spells, alongside their benefit of income protection.
• Misconception: This prize is purely theoretical with no real-world use. Correct: The DMP model is described as the most used tool for analysing real unemployment, wage and vacancy data and for assessing labour-market policy.
• Misconception: Each laureate worked entirely alone. Correct: Mortensen and Pissarides built their core labour-market model jointly, and all three laureates' contributions, spanning decades, build on and respond to each other's work.
• Misconception: "The Nobel Prize in Economics" is identical in origin to the original Nobel prizes named in the citation. Correct: Its full, official name is the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, though it is commonly called the Nobel Prize in Economics.

Exam-style questions with model answers

Q1. State the official citation for the Economic Sciences Prize 2010. [1 mark]

1. The citation reads "for their analysis of markets with search frictions".

Q2. Name the three 2010 laureates and their main affiliations at the time of the award. [2 marks]

1. Peter A. Diamond was at MIT, USA; Dale T. Mortensen was at Northwestern University, USA, and also Aarhus University, Denmark; Christopher A. Pissarides was at the London School of Economics, UK.

Q3. What is a search friction, and why does it matter in the labour market? [3 marks]

1. A search friction is the time, effort or cost that a buyer and a seller, or a worker and a firm, must spend before they find each other and agree to trade.
2. In the labour market, this friction means job seekers do not instantly find openings and firms do not instantly fill vacancies.
3. Because of this, unemployment and job vacancies can exist side by side at the same time, which a frictionless market model cannot explain.

Q4. Explain the Diamond paradox and why it surprised economists. [4 marks]

1. Diamond's 1971 model considered buyers who search sequentially for the best price among many sellers, paying a fixed cost each time they check one more seller.
2. Since all buyers face the same price spread and cost, they settle on the same cut-off price above which they would rather keep searching.
3. Every seller can then safely charge right up to that shared cut-off, which is the highest price buyers will still accept, the same price a monopolist would set.
4. This surprised economists because even a very small search cost was enough to remove all price dispersion and push the market to the monopoly price, far from the usual competitive outcome.

Q5. What are congestion and thick-market externalities, and why do they make search markets inefficient? [4 marks]

1. When one unemployed worker searches harder, it becomes harder for other job seekers to find work, which is the congestion externality.
2. At the same time, it becomes easier for firms to fill their vacancies, which is the thick-market externality.
3. An individual worker, deciding how hard to search, does not take either effect on other people into account.
4. Because these effects on others are ignored, the overall level of search activity, and hence the unemployment rate, generally differs from the level that would be best for society, leaving room for policy intervention.

Q6. Describe the steady-state flow of workers and jobs in the Diamond-Mortensen-Pissarides model. [5 marks]

1. Unemployed workers and vacant jobs meet through a matching function that converts the stocks of job seekers and vacancies into a flow of new hires.
2. How tight the labour market is, meaning the ratio of vacancies to unemployed workers, decides how fast each side finds a match.
3. Once matched, the worker and firm bargain over the wage, splitting the gains from the match according to productivity, unemployment benefits and labour-market tightness.
4. Firms keep opening new vacancies only as long as doing so remains profitable, which fixes the number of vacancies in equilibrium given hiring costs.
5. Existing jobs are destroyed at some rate, returning workers to unemployment and restarting the whole cycle, which keeps the unemployment rate constant in a steady state.

Q7. Discuss how the work of Diamond, Mortensen and Pissarides changed the understanding of unemployment and its policy implications. [6 marks]

1. Before this research, standard market models assumed instant, costless trade, leaving no clear way to explain why unemployment and job vacancies exist at the same time.
2. Diamond's early work on search markets showed that frictions, even small ones, can radically change prices and that search markets are generally not efficient on their own because of externalities between searchers.
3. Mortensen and Pissarides extended this into the Diamond-Mortensen-Pissarides model, a complete framework linking search, matching, wage bargaining and firms' decisions to open vacancies, built mainly through papers from 1985 and 1994.
4. The model explains the Beveridge curve, the observed negative relationship between unemployment and vacancies, and shows how shifts in that curve signal changes in matching efficiency rather than simple demand changes.
5. It is directly useful for policy analysis, showing that more generous unemployment benefits raise unemployment and lengthen search times, while also noting that such benefits provide valuable income protection and can improve the quality of matches.
6. Because the model can be applied to data on vacancies and unemployment flows, it became the standard tool that economists and policymakers use today to evaluate labour-market reforms such as changes to hiring and firing costs.

Key takeaways

• The 2010 Economic Sciences Prize went jointly to Peter A. Diamond, Dale T. Mortensen and Christopher A. Pissarides for analysing markets with search frictions.
• A search friction is the cost, in time or effort, of finding a trading partner, which prevents instant, costless matching.
• Diamond's 1971 Diamond paradox showed that even a tiny search cost can push all sellers to the same, monopoly-level price.
• Search markets generally are not efficient on their own because searchers ignore how their effort affects other job seekers and firms.
• Mortensen and Pissarides built the Diamond-Mortensen-Pissarides (DMP) model, which explains unemployment, vacancies and wages together.
• The Beveridge curve, a negative link between unemployment and vacancies, is explained by the DMP model and used as a real diagnostic tool.
• More generous unemployment benefits tend to raise unemployment and lengthen job searches, though they also protect workers' income.
• Search theory has been applied well beyond the labour market, including to housing markets and other matching problems.

Test yourself

What does the term "search friction" mean?

A search friction is the time, effort or cost that buyers and sellers, or workers and firms, must spend before finding each other and agreeing to trade.

Who were the three laureates of the 2010 Economic Sciences Prize?

The laureates were Peter A. Diamond of MIT, Dale T. Mortensen of Northwestern University and Aarhus University, and Christopher A. Pissarides of the London School of Economics.

What is the Diamond paradox?

It is Diamond's 1971 finding that even a very small search cost can push all sellers in a market to charge the single highest price buyers will accept.

Name the two externalities that make individual job search affect other people.

Congestion externality, where one searcher makes it harder for others to find jobs, and thick-market externality, where one searcher makes it easier for firms to fill vacancies.

What is the Beveridge curve?

It is the generally downward-sloping relationship between the unemployment rate and the job-vacancy rate, named after the economist William Beveridge.

What effect does more generous unemployment insurance have, according to the theory?

It tends to raise the unemployment rate and lengthen the average time unemployed workers take to find a job, though it also protects income.

Which laureate's 1982 paper showed that a search economy could settle into more than one stable pattern of activity?

Peter A. Diamond's 1982 paper showed a search economy could have multiple steady-state equilibria, some with higher activity than others.