Introduction to Search Theory of Unemployment

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2 Economic Review 1998 Q3

An Introduction to the Search Theory of Unemployment
by Terry J. Fitzgerald
Terry J. Fitzgerald is an economist at the Federal Reserve Bank of Cleveland. He thanks Paul Gomme and Randall Wright for their comments, and Jennifer Ransom and Jeff Schwarz for their research assistance.

Introduction On any given day, during economic busts and
economic booms alike, millions of Americans are unable to find desirable employment despite their best efforts. Understanding the reasons for this fact is a chief concern for economists and policymakers, since it is necessary for designing good labor market policies. Unemployment not only creates hardships for those it encompasses, but it also seems to represent a vast pool of idle economic resources. Classical labor theory is not well suited to thinking about unemployment, for within this framework the amount of labor that workers supply is exactly equal to the amount of labor demanded by firms at the equilibrium wage— therefore, there is no unemployment. This feature of classical theory has contributed to the historical interpretation of unemployment, or at least a portion of unemployment, as a disequilibrium or an involuntary phenomena. While such terminology has permeated discussions of unemployment, it has done little to enhance our understanding of the underlying determinants of unemployment or its behavior through time and across countries.1

A different approach to the study of unemployment, which sought to directly explain the frequency and duration of unemployment spells, took root during the 1970s. The building block of this approach is the simple observation that finding a good job (or a good worker, in the case of a firm) is an uncertain process which requires both time and financial resources. This assumption stands in contrast to the classical model, in which workers and firms are assumed to have full information at no cost about job opportunities and workers. The alternative approach, referred to as the search theory of unemployment, seeks to understand unemployment in the context of a model in which the optimizing behavior of workers and firms gives rise to an equilibrium rate of unemployment. Furthermore, it has the potential to explain the striking fact that while millions of workers are unemployed, firms are simultaneously looking to fill millions of jobs.

s 1 See Rogerson (1997) for an excellent discussion of the language used to discuss unemployment.

3 Economic Review 1998 Q3

The search theory approach to understanding unemployment flourished during the 1980s and 1990s. Incorporating the simple observation that searching is costly into a theory of labor markets has resulted in a rich set of models which have helped us not only to understand how unemployment responds to various policies and regulations, but also to gain a better understanding of other labor market issues including job creation and destruction, business cycle characteristics, and the effects of labor market policies on the aggregate economy more generally. Unfortunately, while economists have found modern search theory an invaluable tool for understanding unemployment (as well as numerous other issues), the insights provided by this approach remain largely unfamiliar to noneconomists. This is partly a reflection of the old language of unemployment—terminology such as “full employment’’ and the “natural rate of unemployment’’—continuing to dominate discussions of unemployment in the media and politics. This review is an attempt to reach out to those readers who are interested in acquiring a modern perspective on unemployment by providing an introduction to the search theory of unemployment. In this article I present a model of job search and analyze how an unemployed worker’s decision environment affects not only her employment decisions, but also the overall level of...
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