DEFINITION of Search Theory
Search theory is a study about transactional frictions between two parties that prevent them from a match in an efficient time frame. 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 why.
BREAKING DOWN Search Theory
Two parties that wish to transact in business - an employer and job seeker, 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 even interfere with an efficient search process. For example, overly generous unemployment benefits may induce a qualified worker to sit at home and collect unemployment checks instead of seeking a job.
Economists Peter Diamond, Dale Mortensen and Christopher Pissarides won the 2010 Nobel Prize in Economics for their "analysis of markets with search frictions." Their search theory puzzled over a basic empirical observation that there can be many unemployed job seekers (as opposed to unemployed 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 and 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, findings of their search theory offer guidance to policy makers to adjust unemployment programs to minimize benefit payments and promote more matching activity between buyers and sellers of work.