Diamond, Mortensen & Pissarides (2010): Why Jobs Go Unfilled While People Go Unemployed

The Paradox of Simultaneous Shortage and Surplus

Standard economics has a simple story about markets: if there’s a surplus of workers (unemployment), wages fall until every worker finds a job. If there’s a shortage of workers (vacancies), wages rise until every job is filled. Supply meets demand, and the market clears.

But labor markets never clear. There are always unemployed workers and unfilled jobs at the same time. In the United States, even during economic booms, millions of people are unemployed while millions of jobs sit vacant. This isn’t a temporary glitch — it’s a permanent feature of every economy.

Peter Diamond, Dale Mortensen, and Christopher Pissarides explained why. Their answer: search frictions — the time, effort, and cost required for workers to find suitable jobs and for firms to find suitable workers. This simple insight, developed into a rigorous mathematical framework, became the foundation of modern labor economics.

Diamond: Search Externalities and Market Failure

Peter Diamond laid the theoretical foundations by showing that search frictions fundamentally change how markets work.

In a frictionless market, prices adjust instantly to balance supply and demand. But when searching is costly, something different happens:

• Thick market externalities: The more people participate in a market, the easier it is for everyone to find a match. A job seeker in a city with many employers finds work faster than one in a small town. An employer in a thick labor market fills vacancies faster. Each participant’s search makes everyone else’s search easier — a positive externality
• Multiple equilibria: Diamond showed that search markets can get stuck in bad equilibria. If few people are searching, matches are rare, so even fewer people bother to search — a vicious cycle. Conversely, if many people search, matches are frequent, encouraging even more search — a virtuous cycle. The same economy can settle into a high-activity or low-activity equilibrium
• The coconut model: Diamond’s famous “coconut economy” parable showed that even identical people trading identical goods can end up with inefficient outcomes when search is costly. The market doesn’t automatically find the right level of activity

This meant that unemployment wasn’t just about wages being too high or too low — it was about the fundamental difficulty of matching in a decentralized economy.

Mortensen: Job Creation and Destruction

Dale Mortensen focused on the dynamics of job creation and destruction — the constant churning that characterizes real labor markets.

Key insights:

• The matching function: Mortensen (with Pissarides) formalized the idea that the rate at which unemployed workers and vacant jobs find each other depends on the number of each — more unemployed workers and more vacancies mean more matches, but with diminishing returns
• Wage determination: When a worker and firm meet, they must agree on a wage. Mortensen modeled this as a Nash bargaining problem — the wage splits the surplus from the match between worker and firm, with the split depending on each side’s outside options
• On-the-job search: Workers don’t just search when unemployed — they search while employed too, looking for better matches. This generates job-to-job transitions that are crucial for wage growth and efficient allocation
• Wage dispersion: Even identical workers doing identical jobs can earn different wages — because the randomness of search means some workers happen to find better-paying firms. This explained the persistent wage inequality that competitive models couldn’t account for

Pissarides: The DMP Model

Christopher Pissarides synthesized these ideas into the DMP model (Diamond-Mortensen-Pissarides) — the workhorse framework of modern labor economics.

The model captures the essential dynamics:

• Firms decide whether to post vacancies based on the expected cost of searching for a worker versus the expected profit from a filled position
• Workers decide how intensively to search based on the expected benefit of finding a job versus the cost of searching
• A matching function determines how many matches occur given the number of vacancies and unemployed workers
• Wages are bargained when a match forms, splitting the surplus between worker and firm
• Jobs are destroyed when productivity shocks make them unprofitable

The Beveridge curve — the empirical relationship between unemployment and vacancies — emerges naturally from the model. When the economy is booming, vacancies are high and unemployment is low. When it’s in recession, vacancies are low and unemployment is high. But both always coexist, because matching takes time.

Policy Implications

The DMP model became the standard tool for analyzing labor market policies:

• Unemployment benefits: More generous benefits reduce the cost of being unemployed, making workers pickier about which jobs to accept. This can improve match quality (workers find better-suited jobs) but also increase unemployment duration. The optimal level balances these effects
• Employment protection: Strict firing regulations reduce job destruction but also discourage job creation — firms are reluctant to hire if they can’t fire. The net effect on unemployment is ambiguous
• Active labor market policies: Job placement services, training programs, and hiring subsidies can improve the matching process — reducing frictions directly rather than just compensating for them
• The Beveridge curve as diagnostic: Shifts in the Beveridge curve reveal whether unemployment is cyclical (moving along the curve) or structural (the curve itself has shifted, indicating worse matching efficiency)

Their 2010 Nobel Prize was awarded “for their analysis of markets with search frictions.”

Explain It to a Child

Imagine a school dance where boys stand on one side and girls on the other. Everyone wants to dance, and there are equal numbers of boys and girls. In a perfect world, everyone pairs up instantly. But in reality, it takes time — you have to walk across the room, find someone you like, ask them, maybe get turned down, try again. Some kids are shy. Some are picky. The music is loud and it’s hard to communicate. So at any moment, there are kids standing alone AND kids looking for partners — both at the same time. That’s what happens in the job market: workers are looking for jobs and companies are looking for workers, but finding the right match takes time and effort. Diamond, Mortensen, and Pissarides built the math to explain this dance — and to figure out how to make the matching go faster.