The prize has been awarded to Peter Diamond, Dale Mortensen and Chris Pissarides.
First, let me bask in some Nobel glory and say “I called it!”: in a post last week, I used the Kellogg/NU data to predict this prize. This goes to show that “information aggregation and voting” has one data point in its support.
Dale Mortensen is at Northwestern so I know him a little. I remember having a very fun conversation with Dale and his wife and Ed Prescott (before he won the Nobel Prize himself) at a Schwartz dinner at Northwestern. There was a quite lively discussion of the Iraq war led by Dale’s wife. I’ve never met Chris Pissarides. All I can say as someone raised in the U.K. is that it’s great that a professor at L.S.E. won the Prize. L.S.E. is an amazing intellectual, cosmopolitan institution. Hayek and Coase spent formative years there. It’s wonderful that Pissarides got his PhD at LSE and has spent almost his entire career there. I visited MIT last year but I was too intimidated by Diamond to strike up a conversation!
Here is my attempt to offer some explanation of some papers. My choices are somewhat idiosyncratic as they are the papers I have read rather than perhaps their key papers.
Peter Diamond has a classic paper A Model of Price Adjustment in the Journal of Economic Theory in 1971. Diamond shows that even an infinitesimal search cost can lead to monopoly pricing rather than competitive pricing because of a hold up problem. Suppose there is no search cost and two firms are selling an identical good. The logic of (Bertrand) competition means they will both end up pricing at cost. At any higher price, one firm can undercut the other and capture the entire demand rather than half the demand and double its profit.
Instead suppose there is a small search cost e>0 a consumer must pay to discover the price. Pricing at cost is no longer an equilibrium – one firm can raise its price by almost e. The consumer discovers the higher price once he enters the store. But going to the other store to get a lower price involves a transactions cost of e anyway. So, it is better to submit to hold-up and pay the higher price. This logic obtains at all prices lower than the monopoly price. At that point you do not want to raise the price any more as consumers simply stop buying at a rate than makes further price increases lead to lower profits. So, a small search cost reverses the intuition about pricing completely.
Diamond has made seminal contributions to many areas. He has worked on general equilibrium with incomplete markets, the overlapping-generations model and on public finance (Diamond-Mirrlees).
Of Dale Mortensen’s papers, I know Property Rights and Efficiency in Mating, Racing and Related Games in the American Economic Review in 1982. Suppose parties are trading and have to invest ex ante to increase the ex post value of trade. The investment could be search for a trading partner or R-and-D investment etc. If they do not trade, each goes back into the search market to trade with someone else. If they do trade, any surplus they generate is split 50-50. The latter property implies there a kind of tax on ex ante investment and generates underinvestment. In common with Diamond, there is not only search but also ex post hold-up. In Diamond, the price can be increased by the firm behind the veil of secrecy. In Mortensen, ex post haggling over price generates hold-up. The Mortensen model in AER is closely related to the Grossman-Hart model of incomplete contracts and property right allocation and also to last year’s prize to Oliver Williamson.
Pissarides’s AER 1985 paper Short-Run Equilibrium Dynamics of Unemployment, Vacancies, and Real Wages also assumes unemployed workers and firms bargain over wages ex post. Their share of the surplus depends on their outside option which is turn depends on the tightness of the labor market – intuitively, the more workers are unemployed, the lower the wage firms can charge. In fact, in the simple model Pissarides proposes, it is possible to derive explicit solutions relating unemployment to wages and vacancies and even take the model to data. Hence, the Diamond-Mortensen-Pissarides model has become a canonical model with which to study unemployment. It has been extended in many directions by many authors including Mortensen and Pissarides together.
I guess the DMP model is being used to study unemployment dynamics in the current recession and to propose policy responses. A highly timely prize.