What is Search Theory?

Search theory is a study of transactional frictions between two parties that prevent them from finding an instantaneous match. Search theory has mainly been used to explain inefficiencies in the market for employment, but it also has broad applicability to any form of "buyer" and "seller," whether for a product, house, or even a spouse/partner. Under classical competitive equilibrium models, buyers and seller can transact in a frictionless world with complete and open information; clearing prices are immediately met because supply and demand forces react freely. However, in the real world, this does not happen. Search theory attempts to explain how.

Key Takeaways

  • Search theory explains how buyers and sellers decide when to accept a matching offer for a transaction.
  • Search theory extends economic analysis beyond the idealized world of perfectly competitive markets.
  • Search theory helps explain why frictional unemployment occurs as workers search for jobs and businesses search for new employees.

Understanding Search Theory

In the real world, information is imperfect and costly, transactions involve discrete quantities of goods and services, and buyers and sellers may be separated in space or by other barriers. In other words, parties that wish to transact in business—an employer and job seeker, or a seller of a good and a buyer—encounter frictions in their search for each other. These frictions can take the form of mismatched geographies, price expectations, and specification requirements, as well as slow response and negotiation times by one of the parties involved. Government or corporate policy may further interfere with an efficient search process.

Search theory was originally applied to labor markets but has applications to many subjects in economics. In labor markets, search theory is the basis for explaining frictional unemployment as workers change jobs. It has also been used to analyze consumer choices between different goods. 

In search theory, a buyer or seller faces a set of alternative offers of varying quality and price to accept or reject, as well as a set of preferences and expectations, all of which may vary over time. For workers, this means the wages and benefits of a job in combination with working conditions and characteristics of the job. For consumers, it means the quality of the good and its price. For both, the search depends on their preferences for price and quality and their beliefs regarding other possible alternatives.

Search theory describes the optimal amount of time that the searcher will spend on their search before settling on one alternative to accept. Search time will depend on several factors:

Reservation Price 

First, it depends on the individual’s reservation price (the minimum they are willing to accept/maximum they are willing to pay). For example, a buyer who has a fixed budget of $5,000 cash to spend on a car will search long enough to find a car of suitable quality for under $5,000. Because they raise reservation wages, welfare and unemployment benefits may induce a qualified worker to sit at home and collect unemployment checks instead of seeking a job.

Costly Search

If there are costs that increase with the length of the search, optimal search time will tend to be shorter. For example, if a worker’s skills may degrade or become obsolete over time, then they will tend to shorten their search for a new job. 

Price and Quality Variance

The amount of variation in price and quality of offers will also influence the optimal search length. Greater variation can convince the seeker to hold out longer in their search in expectation of possibly finding a superior alternative. 

Risk Aversion

Risk aversion can also play a part in search time. For example, a longer job search often means that the searcher may be spending down savings and face increasing risk of becoming destitute as the search lengthens. A risk averse seeker will tend to shorten their search under this condition.

Matching Theory

Economists Peter Diamond, Dale Mortensen, and Christopher Pissarides won the 2010 Nobel Prize in Economics for their "analysis of markets with search frictions," involving a two-sided search by both buyers and sellers simultaneously. Their theory puzzled over a basic empirical observation that there can be many unemployed job seekers (as opposed to unemployed persons who are not looking for a job) at a time when there are many job openings that are suitable for them. Diamond initiated search theory research into retail markets, while Mortensen and Pissarides spearheaded focus on labor markets. Their discoveries of frictions that lead to less-than-optimal outcomes have helped to explain chronic unemployment issues, price and wage differences, and inefficient uses of search resources. In turn, the findings of their search theory offer guidance to policy makers to adjust unemployment programs to optimize benefit payments and promote more matching activity between buyers and sellers of work.