Search Theory (Economics) - Explained
What is Search Theory?
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Table of ContentsWhat is Search Theory?How Does Search Theory Work? The Origin of Search TheorySignificance of Search TheoryOther ConsiderationsAcademic Research on Search Theory
What is Search Theory?
Search theory in microeconomics is the study of transactional frictions where buyers or sellers cannot instantly find a matching partner within the required time frame. The situation, therefore, requires them to search for a partner before commencing with the transaction.
How Does Search Theory Work?
When it comes to classical competitive equilibrium models, buyers and sellers operate in a world without friction and with open and complete information. For instance, clearing prices is immediate because supply and demand forces react naturally and freely to ensure this. However, according to macroeconomists, this isnt the case in the real world, and the search theory tries to explain it. For instance, two parties may wish to do a business transaction. It can be a buyer and a seller or a job seeker and an employer who, at some point, will encounter friction in the search for each other. The conflict can be in the following forms:
- Price expectations
- Mismatched geographic
- Specification requirements
- Slow negotiation and response
Besides the forms of friction mentioned above, the corporate or the government policy may also come in to interfere with the search process. A good example is where excessive unemployment benefits lead to a qualified worker staying at home to collect unemployment checks rather than looking for a job.
The Origin of Search Theory
Economists Dale Mortensen, Peter Diamond, and Christopher Pissarides are the ones who came up with the search theory. In their observation, they realized that it is possible to have many unemployed job seekers as opposed to unemployed who are not looking for jobs even when there are job openings that suit their qualifications. So, Diamond started the search theory to research on retail markets, while Pisaarides and Mortensen focused their research on labor markets. In their study, they discovered frictions that cause less-than-optimal outcomes, which could now explain why there are wage and price differences, chronic unemployment, and inefficiency in the use of search resources. Their search theory also guides the policymakers to make adjustments to unemployment programs. It helps in ensuring that there is a minimization of benefit payment as well as the promotion of more matching activities between the sellers and buyers. However, macroeconomists have expanded on the search theory to accommodate the study of general equilibrium models where one or several types of searches interact. These macroeconomic theories have come to be known as matching theory. Others call them to search and matching theory.
Significance of Search Theory
Search theory has been influential in the field of economics. Macroeconomists have used the theory to explain certain efficiencies in the market such as employment. For instance, they have applied it in the area of labor economics to help analyze frictional unemployment that results from workers job hunting. However, the theory also has broad applicability to a buyer and seller when dealing with a product or house transaction among other things. From the perspective of workers, an acceptable job is one that offers high wages, desirable benefits and safe or good working conditions. When it comes to consumers, a product worth purchasing according to them would be that of high quality and offered at a considerably low price. In both scenarios, whether a product or a job is acceptable, it will depend on the beliefs of the searchers on the available options in the market. So, to be more precise, search theory studies the optimal strategy of an individual when selecting from a number of potential random quality opportunities, which holds that delaying choice is costly. What search theory does is to illustrate how you can best balance the delay cost against the options value to try again. If you look at the search models from a mathematics perspective, then you can say that they are optimal stopping problems.
Other economists had different thinking about search theory. For instance, Goerge J. Stigler had proposed that job searching or bargains should be an economic problem. There is also John J. McCall, who came up with a proposal that there should be a dynamic model for a job search based on a mathematical method known as optimal stopping. It is important to note that as a result of Mccalls proposal, his idea has been the base of most work. McCalls paper focused its study on problems which highlighted the following:
- The kind of job offers unemployed population should expect
- The type of employment offers to reject when there is a distribution of alternatives that are well known and constant, including the value of the money
While holding fixed-job characteristics, McCall did characterization of job search decision to be the reservation wage with the lowest salary the worker is ready to accept. In other words, the optimal strategy of the worker is to refuse any wage offer that is lower than the reservation wage and instead take a wage offer that is above the reservation wage. However, there is a possibility of this reservation wage changing with time if the McCalls assumed conditions are not met. For instance, an individual who is not able to get a job will lose his or her skills or face stigma. In this case, according to McCall, the more this person remains unemployed, the distribution of potential offers he or she will receive will get worse by day. For a risk-averse worker, according to McCall, the reservation wage likely to go down with time in case the worker becomes penniless while searching for a job. Also, there is an expectation that the reservation wage will differ when there are two jobs with different features. In other words, the two types of jobs will have a separate compensating differential. So, according to McCall, a higher variance may lead to a better job search and also extend the optimal search, even if the worker is risk-averse. The reason is that even if there are variations in the wages, the search can wait longer with the hope that there will be finally an exceptional wage offer. Note that the possibility of a worker receiving low wage offers has less or no impact on the reservation wage because a worker can turn down a lousy wage offer. Although McCall framed the theory as an unemployed workers wage search decision, the same insight can be applied to a search for a low price by a consumer. In that light, reservation price is the highest price a consumer agrees to pay for a given service or product.