Economics Nobel: Why Unemployment Is Inevitable

High unemployment is now plaguing many nations' economies, but even in the best of times, about one out of every 25 workers will be out of a job. This year's winners of the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel laid out the theory that explains why full employment is impossible.

Peter Diamond, 70, of the Massachusetts Institute of Technology (MIT) in Cambridge; Dale Mortensen, 71, of Northwestern University in Evanston, Illinois; and Christopher Pissarides, 62, of the London School of Economics will split the $1.5 million prize. Starting in the 1970s they developed, mostly independently, the theory of markets that suffer "search friction," or costs for consumers and suppliers of a good to find one another. Dubbed the "DMP theory" in the economists' honor, it has become the bedrock for the study of labor markets and explains why people are sure to be out of work even when the number of vacant jobs equals the number of job seekers, so-called equilibrium unemployment.

"It's a wonderful choice," says Michael Elsby, an economist at the University of Michigan, Ann Arbor, of the trio's honor. "If you're going to be thinking about unemployment, you're going to start by playing around with the DMP model."

Classical economics predicts that unemployment should vanish whenever the number of available jobs equals or exceeds the number of workers. In reality, that never happens. For example, even during the economic boom a decade ago, unemployment in the United States dipped only as low as 3.8%.

Diamond, Mortensen, and Pissarides found that they could explain that fact. They began with a dynamical model that considers the flow of workers both into jobs and out of jobs. They imposed costs for an unemployed worker to find a job and for an employer to find a suitable employee, which affected the flows. The economists then showed mathematically that a new equilibrium would arise with at least some unemployment, the amount of which depended on the costs.

In the 1960s, much of economic theory strived to prove that the results from idealized classical economics still held sway as economists made their models more realistic, Diamond said at an MIT press conference after the prize was announced. He preferred to let the improved models lead where they may. "It seemed to me that a better approach was to think about real dynamics and see where they go," he says. "Maybe they go to the [classical] equilibrium solution, and maybe they don't."

Although the DMP theory started out as a mathematical abstraction, it has become a tool for applied economists and policymakers. That's because it provides a framework for studying in detail the effectiveness of a specific intervention in reducing unemployment or ameliorating its effects. "There's a whole literature out there on unemployment insurance that uses the model," says Stephen Woodbury, an economist at Michigan State University in East Lansing.

Given the unemployment crunch afflicting many countries, Pissarides says he favors political action to get people back to work. "What we should really be doing is to ensure that they do not stay unemployed too long," he said at another press conference. "Give them direct work experience—not necessarily advanced training—after a few months so they don't lose touch with the labor market."