Job #: 72931 Author name: woodbury Title of book: search theory and unemployemtn ISBN number: 140207333x SEARCH THEORY AND UNEMPLOYMENT RECENT ECONOMIC THOUGHT SERIES Editors: William Darity, Jr. James K. Galbraith University of North Carolina University of Texas at Austin Chapel Hill, North Carolina, USA Austin, Texas, USA Other books in the series: Menchik, Paul L.: HOUSEHOLD AND FAMILY ECONOMICS Gupta, Kanhaya L.: EXPERIENCES WITH FINANCIAL LIBERALIZATION Cohen, Avi J., Hagemann, Harald, and Smithin, John: MONEY FINANCIAL INSTITUTIONS AND MACROECONOMICS Mason, P.L. and Williams, R.M.: RACE, MARKETS, AND SOCIAL OUTCOMES Gupta, Satya Dev: THE POLITICAL ECONOMY OF GLOBALIZATION Fisher, R.C.: INTERGOVERNMENTAL FISCAL RELATIONS Mariussen, A. and Wheelock, J.: HOUSEHOLDS, WORK AND ECONOMIC CHANGE: A COMPARATIVE INSTITUTIONAL PERSPECTIVE Gupta, Satya Dev: GLOBALIZATION, GROWTH AND SUSTAINABILITY Gupta, Satya Dev: DYNAMICS OF GLOBALIZATION AND DEVELOPMENT Medema, Steven G.: COASEAN ECONOMICS: LAW AND ECONOMICS AND THE NEW INSTITUTIONAL ECONOMICS Peoples, James: REGULATORY REFORM AND LABOR MARKETS Dennis, Ken: RATIONALITY IN ECONOMICS: ALTERNATIVE PERSPECTIVES Ahiakpor, James C.W.: KEYNES AND THE CLASSICS RECONSIDERED Wolfson, Murray: THE POLITICAL ECONOMY OF WAR AND PEACE Jain, A.K.: ECONOMICS OF CORRUPTION Wheelock, J. and Vail, J.: WORK AND IDLENESS: THE POLITICAL ECONOMY OF FULL EMPLOYMENT Dean, James M. and Waterman, A. M.C.: RELITION AND ECONOMICS: NORMATIVE SOCIAL THEORY Gupta, Kanhaya: FOREIGN AID: NEW PERSPECTIVES MacDonald, R. and Stein, J.: EQUILIBRIUM EXCHANGE RATES Chilcote, Ronald M.: THE POLITICAL ECONOMY OF IMPERIALISM: CRITICAL APPRAISALS Silber, Jacques: HANDBOOK ON INCOME INEQUALITY MEASUREMENT Elsner, W. and Groenewegen, J.: INDUSTRIAL POLICIES AFTER 2000 Young, W. And Zilberfarb, B.: IS-LM AND MODERN MACROECONOMICS Dopfer, Kurt: EVOLUTIONARY ECONOMICS: PROGRAM AND SCOPE Akhand, H. A. and Gupta, K L.: FOREIGN AID IN THE TWENTY-FIRST CENTURY SEARCH THEORY AND UNEMPLOYMENT edited by Stephen A. Woodbury Michigan State University and Cari Davidson Michigan State University .... " Springer Science+Business Media, LLC Library of Congress Cataloging-in-Publication Data SEARCH THEORY AND UNEMPLOYMENT Stephen A. Woodbury and CarI Davidson ISBN 978-94-010-4003-7 ISBN 978-94-010-0235-6 (eBook) DOI 10.1007/978-94-010-0235-6 A c.I.P. Catalogue record for this book is available from the Library of Congress. Copyright ©2002 Springer Science+Business Media New York Originally published by Kluwer Academic Publishers, New York in 2002 Softcover reprint of the hardcover I st edition 2002 Ali rights reserved. No part of this work may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, microfilming, recording, or otherwise, without written permis sion from the Publisher, with the exception of any material supplied specifically for the purpose of being entered and executed on a computer system, for exclusive use by the purchaser of the work. Permis sion for books published in Europe: [email protected] Permissions for books published in the United States of America: [email protected] Printed an acid-free paper. Table of Contents 1. Search Theory and Unemployment: An Introduction .......................................... 1 Carl Davidson and Stephen A. Woodbury 2. Search Theory Rediscovered: Recent Developments in the Macroeconomics of the Labor Market ............................................................... 17 MonikaMerz 3. Search, Bargaining, and the Business Cycle ...................................................... 45 Dan A. Black and Mark A. Loewenstein 4. Search Externalities in an Imperfectly Competitive Economy ........................... 69 Andrew John 5. Empirical Search Models ................................................................................... 93 Jose J. Canals and Steven Stern 6. Variation in the Impact of Benefit Exhaustion on Unemployment Duration .................................................................................. 131 John B. Engberg 7. Offer Arrivals Versus Acceptance ................................................................... 155 Theresa J. Devine 8. Optimal Unemployment Insurance with Risk Aversion and Job Destruction ......................................................................................... 177 Carl Davidson and Stephen A. Woodbury 9. Macroeconomic Policy and the Theory of Job Search ..................................... 215 Bruce C. Fallick and William L. Wascher Index ....................................................................................................................... 239 Preface The past twenty-five years have seen a remarkable growth of research on unemployment that takes as its starting point the economic theory of job search. This volume contains eight papers (following an introduction) that trace the development of job search theory and its implications for empirical work and public policy. Following the introductory chapter, chapters 2, 3, and 4 focus on job search theory itself, chapters 5, 6, and 7 treat econometric issues and the estimation of job search models, and chapters 8 and 9 discuss the application of job search theory to public policy. Drafts of the chapters were first presented at sessions organized by the editors at various regional economic association meetings. We are grateful to the authors and other participants in those sessions-particularly William Alpert, Louis Jacobson, Derek Neal, and Wayne Vroman-for their insightful comments on the drafts. 1 Search Theory and Unemployment: An Introduction Carl Davidson Michigan State University Stephen A. Woodbury Michigan State University and W. E. Upjohn Institute Abstract The first part of this introductory chapter offers a brief historical survey of job search theory. The goals are to give the reader a sense of how search theory arrived at its current state, to point out some of the roadblocks that search theory has encountered, and to suggest how search theoretic models have evolved so as to overcome those roadblocks. The second part of the chapter offers a brief description of each chapter in the book. Eight chapters follow the introduction, with three devoted to job search theory itself, three to estimating job search models, and two to applying job search theory to public policy. S. A. Woodbury et al. (eds.), Search Theory and Unemployment © Kluwer Academic Publishers, 2002 2 Carl Davidson and Stephen A. Woodbury Unemployment is a persistent and pervasive problem in developed economies. In the last 20 years, every industrialized nation has seen an unemployment rate of 10 percent at least briefly-and in many cases (in Europe and Japan) over a period of years. Industrialized nations spend substantial resources to provide a social safety net for workers who find themselves without a job. Many governments also design and implement programs aimed at either increasing job security (e.g., fIring taxes imposed on firms in some European countries) or reducing the time it takes to become reemployed (e.g., government-assisted job search or training programs). It is remarkable, then, that forty years ago economists had no rigorous explanation of how unemployment could arise and persist in equilibrium. Ad hoc theories existed about "money illusion" and downwardly rigid wages, but it was understood that money illusion could only cause changes in unemployment (it could not explain its existence), and no satisfactory explanation existed of why wages would not fall in the presence of excess supply in the labor market. Economists could not explain unemployment because of the profession's continued reliance on the pristine model of supply and demand as its workhorse. This model rules out (by assumption) all types of transaction costs that might keep markets from operating efficiently. Uncertainty is ruled out, informational problems are assumed away, and economic agents on opposite sides of the market have no diffIculty fInding each other. Without the presence of such transaction costs, it is hard to imagine unemployment arising as an equilibrium phenomenon. In the late 1960s, a revolution began in microeconomics as the supply and demand models of Marshall and Walras began to be replaced by models that took transaction costs seriously and used them to explain a wide variety of economic phenomena. For example, the economics of uncertainty provided an explanation of how insurance markets function while the economics of information explained how identical products could sell for different prices in equilibrium. Among the most important developments offered by "transaction cost economics" were the new models of equilibrium unemployment. These models began to emerge following publication of George Stigler's classic 1961 article on "The Economics of Information." This paper, which many cite as the article that inspired much of the subsequent work on transaction costs, examined the problem faced by a consumer searching for a good that was offered by many firms at different prices. Stigler (1962), J.J. McCall (1965), Dale Mortensen (1970), and others quickly extended the analysis to include the problem faced by an unemployed worker searching for a job across fInns that pay different wages. Unemployment would arise if the worker could not fInd a firm with a vacancy or if it was in the worker's interest to turn down a wage offer that he or she considered too low. Other theories of unemployment quickly followed. For example, contract theory explained how optimal contracts between risk-neutral firms and their risk-averse employees in the presence of uncertainty and/or asymmetric information might lead Search Theory and Unemployment 3 to underemployment; that is, a lower level of employment than what would have occurred in a world of certainty and complete information. Efficiency wage models demonstrated that unemployment could arise in equilibrium if firms faced difficulty in monitoring and observing the level of effort exerted by workers on the job. These theories differed from the previous ad hoc explanations of unemployment in that they offered models in which the transaction costs that generated unemployment were completely and carefully specified. Moreover, these theories were internally consistent in that they all provided explanations of unemployment that could persist in equilibrium even though all economic agents were rational and behaving optimally. Forty years after publication of Stigler's classic article seems an appropriate time to take stock of the new theories of unemployment. Have they really increased our understanding of unemployment? Have they generated insights that could be used to design policies that aid the poor or jobless in better or more efficient ways? What are the weaknesses of these theories that still need to be addressed? This book offers a series of chapters that address these questions for the theory of unemployment that many believe to be most compelling and that has arguably generated the most research to date-search theory. The main message is twofold. First, search theory has been enormously successful in a number of important ways. It has increased understanding of unemployment, provided explanations for a wide variety of observed labor market phenomena, and provided a useful framework for policy analysis. Second, although search theory has taken us in the right direction, it still has far to go. Serious questions about the importance of the theory and methods used for policy analysis remain unanswered. Thus, our hope is that the collection of papers offered here provides a critical, well-balanced view of search theory as it stands today. The remainder of this introduction is in two parts. The first is a brief survey of how search theory has arrived where it is today. This survey is in not meant to be exhaustive-surveys of the early work in search theory available elsewhere (for example, Mortensen 1986, Davidson 1990, and Mortensen and Pissarides 1999). Further, Monica Merz provides an excellent and up-to-date survey of search theory and the role that it has played in macroeconomics in Chapter 2, and Jose Canals and Steven Stern survey the empirical methods in the field in Chapter 5. Rather, the goal here is to point out some of the roadblocks that search theory has had to overcome and to give the reader a sense of how the basic models of search theory have had to change over time in response. By taking this historical perspective, we hope to emphasize how far search theory and the models of unemployment it offers have come in so short a time. The second part of this introduction offers a very brief description of each of the chapters in the book. Eight chapters follow the introduction, with three devoted to theory, three to empirical work, and two to policy issues. For any school of economics to survive and thrive, it must be successful in all three. With respect to