Wednesday, November 3, 2010

Nobel Prize 2010

Peter Diamond and two others were awarded the Nobel Prize for finding that “Most real-world transactions involve various forms of impediments to trade or ‘frictions.’” I thought we already knew that. The Swedish Academy notes that “The question of why unemployment exists and what can and should be done about it is one of the most central issues in economics. Labor markets do not appear to ‘clear’: there are jobless workers who search for work (unemployment) and firms that look for workers (vacancies). It has proven a challenge to formulate a fully specified equilibrium model that generates both unemployment and vacancies.”
The millions of unemployed today must be very grateful that this model has been created! Frictional unemployment is certainly not the problem of today. Diamond is applauded for showing that with friction the only equilibrium is the monopoly price. A surprising finding according to the Academy. This is the conventional plaything of conventional economics--all our problems are due to inefficiencies. Diamond “found” that some workers create externalities for other workers by searching too hard--shame on them!
The Academy notes that optimal search behavior involves a reservation wage, at which a worker is indifferent between accepting a job and remaining unemployed. “The reservation wage is thus set so as to equate the value of unemployment, whose immediate return is any unemployment benefit the worker receives, to the resent discounted value of future wage incomes from the job, which involves the likelihood of keeping the job, the interest rate by which the future earnings are discounted, and any expected wage movements on the job.” I’m sure the unemployed will be glad to learn that this is what they are doing. Why is it that many models turn out to blame the worker for their problems and/or the government being too generous with unemployment benefits?
I would give a prize to anyone with insight into labor markets with fluctuating demand for consumer goods. To do this would require economists to get out of their armchairs and talk to people, both labor and management. Have these people ever visited a state unemployment office with its lines of people looking for work or long lines at any employer advertising hires. Then they might truly discover (not deduce) how expectations work and vicious cycles of lower consumer demand leading to laying off workers, to further decline in income and consumer demand. It is time to study institutions and behavior and quit worrying about blackboard mechanical equilibrium models. These models don’t “find” anything, but are just inevitable deductions from the framework used to create them.

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