Prof. Ben Heijdra: the simple, yet important theory of this year's Nobel Prize Winners in Economics

FEB macroeconomics professor Ben Heijdra is proud to see that his 'Economic Hero' Peter Diamond, his Aarhus seminar/dinner companion Dale Mortensen, and the teacher of his research companion Laurie Reijnders, Christopher Pissarides, have been awarded the prize. Heijdra met with Mortensen, just six weeks before his Nobel Prize was announced. In this column he says that macroeconomics remains the most exciting part of economics, also in the view of the Nobel Committee since of the 42 prizes, 7 went to macroeconomists.

"It is a small world indeed"

By: Ben J. Heijdra, Professor of Macroeconomics at the FEB

On August 30th I gave a seminar in Aarhus (Denmark) on my most recent working paper entitled "The Tragedy of Annuitization". This paper is co-authored with Jochen Mierau (Ph.D. student in Groningen) and Laurie Reijnders (Masters student at the London School of Economics). It shows that markets can -- and generally will -- fail even if all participants behave in a perfectly competitive way -- hence the "tragedy" mentioned in the title.

Perhaps an even more interesting aspect of my Danish seminar was the presence in the audience of an American professor from Northwestern University, Dale T. Mortensen. I knew Mortensen from eleven years ago when I had invited and hosted him as one of the NAKE workshop speakers in December 1999. Dale liked the paper, posed some penetrating questions, we went for dinner with him and his wife Beverly in the evening. And we generally had a great time.

To my great delight I heard about six weeks later that Dale Mortensen was awarded the 2010 Nobel Memorial Prize in Economics Sciences together with Peter Diamond (Massachusetts Institute of Technology) and Christopher Pissarides (London School of Economics and now Laurie Reijnders' macro teacher).

Peter Diamond is a giant in the fields of microeconomics, public finance, and macroeconomics, a real homo universalis who should have won the Nobel prize many years before. The idea which won him this year's prize is a simple as it is important. Markets do not coordinate the plans of demanders and suppliers in the frictionless way often seen in first-year textbooks. Instead, Diamond argued, both sides of a market must incur search costs to locate suitable trading partners.

Mortensen and Pissarides accepted Diamond's challenge and further developed his ideas in a labour market context. There the market consists of firms with vacancies searching for unemployed job-seeking workers who could fill these vacancies. In the Diamond-Mortensen-Pissarides (DMP) framework there will be unemployment even in equilibrium, despite the fact that all parties in the market behave competitively. In general the quilibrium unemployment rate need not be efficient, i.e. some form of government intervention may lead to a better equilibrium.  

Generations of third-year FEB students have been weaned on the fundamental insights by this year's Nobel prize. Indeed, their contributions are so fundamental that I devoted an entire chapter on them in my Foundations of Modern Macroeconomics (Oxford University Press, 2010). As of 2010 a total of 42 economics Nobel prizes have been awarded to 67 individuals (complete list here). Of these, seven awards have been for contributions in the field of macroeconomics. This makes macroeconomics the most awarded fields of all!

You cannot begin to imagine how proud I am to see that my Economic Hero (Peter Diamond), my Aarhus seminar/dinner companion (Mortensen), and Laurie Reijnders' macro teacher (Pissarides) have been awarded the prize for their analysis of markets with search frictions. If there is one thing one can learn from macroeconomics it is this lesson. Markets do not always work very well and public intervention is often called for. The field of macroeconomics is far from complete and it remains the most exciting part of economics, both in my view and that of the Nobel Committee.