Northwestern’s sole Nobel Laureate in economics, Dale Mortensen, passed overnight; he remained active as a teacher and researcher over the past few years, though I’d be hearing word through the grapevine about his declining health over the past few months. Surely everyone knows Mortensen the macroeconomist for his work on search models in the labor market. There is something odd here, though: Northwestern has really never been known as a hotbed of labor research. To the extent that researchers rely on their coworkers to generate and work through ideas, how exactly did Mortensen became such a productive and influential researcher?
Here’s an interpretation: Mortensen’s critical contribution to economics is as the vector by which important ideas in micro theory entered real world macro; his first well-known paper is literally published in a 1970 book called “Microeconomic Foundations of Employment and Inflation Theory.” Mortensen had the good fortune to be a labor economist working in the 1970s and 1980s at a school with a frankly incredible collection of microeconomic theorists; during those two decades, Myerson, Milgrom, Loury, Schwartz, Kamien, Judd, Matt Jackson, Kalai, Wolinsky, Satterthwaite, Reinganum and many others were associated with Northwestern. And this was a rare condition! Game theory is everywhere today, and pioneers in that field (von Neumann, Nash, Blackwell, etc.) were active in the middle of the century. Nonetheless, by the late 1970s, game theory in the social sciences was close to dead. Paul Samuelson, the great theorist, wrote essentially nothing using game theory between the early 1950s and the 1990s. Quickly scanning the American Economic Review from 1970-1974, I find, at best, one article per year that can be called game-theoretic.
What is the link between Mortensen’s work and developments in microeconomic theory? The essential labor market insight of search models (an insight which predates Mortensen) is that the number of hires and layoffs is substantial even in the depth of a recession. That is, the rise in the unemployment rate cannot simply be because the marginal revenue of the potential workers is always less than the cost, since huge numbers of the unemployed are hired during recessions (as others are fired). Therefore, a model which explains changes in churn rather than changes in the aggregate rate seems qualitatively important if we are to develop policies to address unemployment. This suggests that there might be some use in a model where workers and firms search for each other, perhaps with costs or other frictions. Early models along this line by Mortensen and others were generally one-sided and hence non-strategic: they had the flavor of optimal stopping problems.
Unfortunately, Diamond in a 1971 JET pointed out that Nash equilibrium in two-sided search leads to a conclusion that all workers are paid their reservation wage: all employers pay the reservation wage, workers believe this to be true hence do not engage in costly search to switch jobs, hence the belief is accurate and nobody can profitably deviate. Getting around the “Diamond Paradox” involved enriching the model of who searches when and the extent to which old offers can be recovered; Mortensen’s work with Burdett is a nice example. One also might ask whether laissez faire search is efficient or not: given the contemporaneous work of micro theorists like Glenn Loury on mathematically similar problems like the patent race, you might imagine that efficient search is unlikely.
Beyond the efficiency of matches themselves is the question of how to split surplus. Consider a labor market. In the absence of search frictions, Shapley (first with Gale, later with Shubik) had shown in the 1960s and early 1970s the existence of stable two-sided matches even when “wages” are included. It turns out these stable matches are tightly linked to the cooperative idea of a core. But what if this matching is dynamic? Firms and workers meet with some probability over time. A match generates surplus. Who gets this surplus? Surely you might imagine that the firm should have to pay a higher wage (more of the surplus) to workers who expect to get good future offers if they do not accept the job today. Now we have something that sounds familiar from non-cooperative game theory: wage is based on the endogenous outside options of the two parties. It turns out that noncooperative game theory had very little to say about bargaining until Rubinstein’s famous bargaining game in 1982 and the powerful extensions by Wolinsky and his coauthors. Mortensen’s dynamic search models were a natural fit for those theoretic developments.
I imagine that when people hear “microfoundations”, they have in mind esoteric calibrated rational expectations models. But microfoundations in the style of Mortensen’s work is much more straightforward: we simply cannot understand even the qualitative nature of counterfactual policy in the absence of models that account for strategic behavior. And thus the role for even high micro theory, which investigates the nature of uniqueness of strategic outcomes (game theory) and the potential for a planner to improve welfare through alternative rules (mechanism design). Powerful tools indeed, and well used by Mortensen.