Introduction to Labor Search Models

Diamond, Mortensen, & Pissarides Model

Dr. Parag Waknis

Ambedkar University Delhi

Macro II Winter 2020

April 28, 2020

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 McCall Model’s Implications for
Aggregate Employment

• Let ut denote the fraction of agents unemployed.

• Probability that the individual agent transits from
unemployment to employment: ut [1 − F(w∗ )].
• Flow of agents out of employment to unemployment is the
number of separations (1 − ut )δ.

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 McCall Model’s Implications for
Aggregate Employment
Law of motion for unemployment is given by:

ut+1 = ut − ut [1 − F(w∗ )] + (1 − ut )δ
= ut [F(w∗ ) − δ] + δ

As both F(w∗ ) and δ lie in (0, 1), |F(w∗ ) − δ| < 1. This implies
that ut converges to constant.

⇒ ut+1 = ut = u

Using this in above equation we get:

δ
u=
δ + 1 − F(w∗ )
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 McCall Model’s Implications for
Aggregate Employment
• Number of unemployed increases as the separation rate
increases, and as the reservation wage increases.
• A higher reservation wage reduces the job-finding rate,
1−F(W∗ ), increasing the unemployment rate.
• Note that reservation wage also depends on separation
rate.
• A higher separation rate increases the flow from
employment to unemployment, increasing the
unemployment rate
• But it also will reduce the reservation wage, which will
reduce the unemployment rate.
• Net effect of change in separation rate on unemployment
rate is ambiguous.
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 Why Two Sided Search?

• Wage distribution in reality could be endogenous-

affected by number of unemployed searching for jobs
and number of vacancies being posted by firms.
• Where are unemployment benefits coming from? In
general equilibrium they will have to come from lump sum
taxes on the employed!

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Two Sided Search

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 Two Sided Search

The Sveriges Riksbank Prize in Economic Sciences in Memory

of Alfred Nobel 2010 was awarded jointly to Peter A.
Diamond, Dale T. Mortensen and Christopher A. Pissarides
”for their analysis of markets with search frictions.”

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 Two Sided Search-
Diamond-Mortensen-Pissarides (DMP)
Model
• A continuum of workers with unit mass with preferences
given by:
∑∞
E0 β t ct
t=0
1
where ct is consumption and β = 1+r .
• An infinite mass of firms, with each firm’s preferences
given by:
∑∞
E0 β t (πt − xt )
t=0

where πt denotes firm’s profits, which are consumed by

firm and xt denotes any disutility from posting a vacancy
during period t. . . . . . . . . . . . . . . . . . . . .
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 Two Sided Search-DMP Model

• Goods are perishable.

• No assets in the model- savings zero each period.
• Let ut denote the fraction of agents unemployed.
• 1 − ut mass of workers who are matched with firms,
producing output, and therefore employed.
• Let vt be the mass of firms which post vacancies in period
t.

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 DMP Model- Matching Function

Implications of labor market trade

Matching function: mt = m(ut , vt ) where mt are the mass of
matches between unemployed workers and firms posting
vacancies.

Properties of Matching function

• m(., .) is continuous,
• increasing in both arguments,
• concave,
• homogenous of degree 1,
• m(0, v) = m(u, 0) = 0 for all v, u ≥ 0.

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 DMP Model- Matching Function
• Trade in labor market is a decentralized economic
activity.
• It is uncoordinated, time consuming, and costly for both
firms and workers.
• Firms and workers spend resources before job creation
and production can take place.
• Trade in labor market is a nontrivial economic activity
because of existence of heterogeneities, frictions, and
information imperfections.
• Matching function gives the outcome of the investment of
resources by firms and workers in the trading process as
a function of inputs.
• Similar to aggregate production function tool in
macroeconomics.
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 DMP Model- Matching Function

• Probability with which an unemployed worker is matched

with a firm posting in period t is given by
m(ut ,vt )
ut = m(1, uvtt ). (Using the homogeneity property)
• Probability that an individual firm posting a vacancy is
matched with a worker is m(uutt,vt ) = m( uvtt , 1)

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 DMP Model- Matching Function

Labor Market Tightness

Define θ = uvtt , where θt is a measure of labor market tightness
in period t.
• An increase in θ increases the job finding probability for
an unemployed worker.
• An increase in θ decreases the probability that a firm can
fill a job.
• Assume that: limθ→0 m( 1θ , 1) = limθ→∞ m(1, θ) = 1

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 DMP Model- Market tightness

• Market tightness refers to relative number of traders

present on both sides of the market.
• For any given trader, a positive externality arises
whenever the number of traders on the opposite side of
the market increases.
• A negative externality arises whenever the number of
agents on the same side of the market increases-also
referred to as congestion.

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 DMP Model- Model Setup

• With firm’s production technology, y units of output can

be produced with one unit of labor input.
• Each worker has one unit of time available each period.
• When a worker and firm meet, and agree to a contract,
they can then jointly produce y units of output each
period until they become separated with probability δ.
• While unemployed, a worker receives unemployment
insurance compensation of b each period
• A firm posting a vacancy incurs a cost in terms of utility of
k each period the vacancy is posted.
• Any firm not posting a vacancy and not matched with a
worker receives zero utility.

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 DMP Model- Setup

• Concentrate on steady state equilibria where ut = u and

vt = v for all t.
• When a worker and firm meet, they will negotiate a
wage w, payment made to the worker in each period
until the firm and worker are separated.
• Let W(w) denote the value of the match to a worker if the
wage is w.
• Let J(y−w) denote the value of the match to the firm.
• Let U denote the value to the worker of remaining
unemployed.
• Let V the value to the firm of posting a vacancy.

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 DMP Model- Setup

Bargaining on surplus from the match

A worker and firm will bargain on the share of total surplus
from a match. An agreement requires:
• Surplus of worker from the match: W(w) − U ≥ 0.
• Surplus for the firm from the match: J(y − w) − V ≥ 0

Total Surplus
Sum of worker’s and firm’s surplus from the match gives the
total surplus: W(w) + J(y−w)−U−V.

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 Bargaining- Determination of w

Nash Bargaining
For determination of the equilibrium wage, Suppose that the
firm and worker engage in bargaining:

w = arg max[W(w′ ) − U]α [J(y − w′ ) − V]1−α

w′

subject to:

W(w′ ) − U ≥ 0
J(y − w′ ) − V ≥ 0

where α is a measure of the worker’s bargaining power, with

0≤α≤1
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 Bargaining- Determination of w

• In equilibrium, occupied jobs yield a total return that is

strictly greater than the sum of the expected returns of a
searching firm and a searching worker.
• On separation each of firm and worker will have to go
through costly search process before meeting another
partner.
• Since all job-worker pairs are equally productive,
expected joint return of the firm and the worker after they
form new matches must be the same as the joint return of
current one.

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 Bargaining- Determination of w

• Hence, a realized job match yields some pure economic

rent equal to the sum of expected search costs of the firm
and the worker (including forgone wages and profits).
• Total surplus represents this economic (local-monopoly)
rent, in addition to compensating each side for its costs
from forming the job.
• This monopoly rent is shared according to Nash solution
to a bargaining problem.

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 Bargaining- Determination of w

Two questions:
• What is arg max?
• What is Nash Bargaining?

Let us look at the answers to each of these questions in detail.

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 arg max

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 Bargaining- Determination of w

Wage derived from from the (generalized) Nash bargaining

solution is the w that maximizes the weighted product of the
worker’s and the firm’s net return from the job match.

Ignoring the constraints in the above optimization problem for

now, the first-order condition for a maximum simplifies to give:

αW′ (w)[J(y − w) − V] − (1 − α)J′ (y − w)[W(w) − U] = 0 (1)

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 DMP Model-Value functions

Value function for an employed worker

For a worker, the value of being employed at wage w, as of
the end of the period, is given by

1
W(w) = w + [(1 − δ)W(w) + δU] (2)
1+r

Value of a match for a firm

The value of a match for a firm, given the wage w, is

1
J(y − w) = y − w + [(1 − δ)J(y − w) + δV] (3)
1+r

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 DMP Model-Value functions

Simplifying these two Bellman equations, just as we did for the

one-sided search model, gives, respectively,

rW(w) = w + δ[U − W(w)] (4)

rJ(y − w) = y − w + δ(V − J(y − w)) (5)
Therefore, form above two equations we get:

w + δU
W(w) = (6)
r+δ

and
y − w + δV
J(y − w) = (7)
r+δ

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 DMP Model-Value functions

Value function for an unemployed worker

1
U=b+ {m(1, θ)W + [1 − m(1, θ)]U}
1+r
⇒ rU = b + m(1, θ)(W − U) (8)

Value of a vacancy for a firm

{ }
1 1 1
V = −k + m( , 1)J + [1 − m( , 1)]V
1+r θ θ
1
⇒ rV = −k + m( , 1)(J − V) (9)
θ

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 DMP Model-Value functions

• In steady state, firms have to be indifferent between their

alternative opportunity which yields zero value and
posting a vacancy.
• ⇒ V = 0 which is the zero profit condition.
Using the zero profit condition in equation (9), we get:

k
J= (10)
m( 1θ , 1)

Using the zero profit condition in equation (7), we get:

y−w
J= (11)
r+δ

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 DMP Model-Job creation condition

Job creation condition

Combining equation (10) & (11) gives the following:

k(r + δ)
y−w− =0 (12)
m( 1θ , 1)

• corresponds to marginal product condition for demand

for labor.
• y is the marginal product of labor.
k(r+δ)
• is the expected capitalized value of firm’s hiring
m( θ1 ,1)
cost.
• Gives a downward sloping line in θ, w space.

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 DMP Model-Job Creation Condition

Equation (12) is one of the key equations constituting

equilibrium of the model.

Second key equation is related to wages- we turn to its

derivation now.

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 DMP Model-Nash Bargaining FOC

Let us start with simplifying the first order condition, (1) of the
Nash Bargaining Problem.

From equations (6) and (7), we get W′ (w) = J′ (y − w) = 1

r+δ .
Using this in equation 1, we get:

α(J(y − w) − V) − (1 − α)(W(w) − U) = 0 (13)

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 DMP Model-Real Wage Rate

Using equations (10) and (11) in (13) and using V = 0 we get

the following for real wage rate, w:

w = rU + α(y − rU) (14)

Workers receive their reservation wage rU and a fraction α of
the net surplus that they create by accepting the job: product
value net of what they give up rU.

If we substitute for rU then we will get a more useful

expression for w which we will use in equilibrium
determination.

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 DMP Model-Wage setting condition

Using equations (8) and (13), we get the following for rU:

α m(1, θ)
rU = b + k
(1 − α) m( 1θ , 1)
α
⇒ rU = b + θk (15)
(1 − α)
Using (15) in (14) and simplifying we get:

w = b + α(y − b + θk) (16)

i.e. Nash bargaining results in the worker receiving
compensation for lost leisure b and a fraction α of both the
firm’s output in excess of b and the economy’s average
vacancy cost per unemployed worker.

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 DMP Model-Wage setting condition

• Workers are rewarded for saving hiring costs that the

representative firm enjoys when the job is formed.
• A higher θ indicates that jobs arrive to the workers at a
higher rate than workers do to the vacant jobs, relative to
an equilibrium with lower θ.
• Equation (16) replaces the labor supply curve from
Walrasian models.
• Walrasian labor supply curve in this model is vertical one
at fixed labor supply and participation.
• Existence of local monopoly power and sharing rule used
to solve for wages implies a upward sloping relation in
θ, w space despite fixed labor supply.

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 DMP Model-steady state equilibrium

Steady state implies that:

• flow of workers from unemployment to employment is
um(1, θ).
• flow of workers from employment to unemployment is
(1 − u)δ.
• both these flows are equal

δ
⇒u= (17)
m(1, θ) + δ
and given the definition of θ, we then have:

δθ
v = uθ = (18)
m(1, θ) + δ

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 DMP Model-steady state equilibrium

Equation (17) shows that for given δ and θ, there is a uniques

equilibrium unemployment rate.

When drawn in vacancy-unemployment space, (17) is

represented by a downward-sloping and convex to the origin
curve called as the Beveridge curve.

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 DMP Model-steady state equilibrium

Steady State Equilibrium

Equilibrium is a triple (u, θ, w) that satisfies (12),(16), and (17).

• For a given real interest rate, r, (12), and (16) determine

wage rate and the ratio of vacancies to unemployment.
• For the given ratio of vacancies to unemployment, (17)
determines the unemployment.

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DMP Model-steady state equilibrium

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DMP Model-steady state equilibrium

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 References

1 Ljungqvist, Lars & Sargent, Thomas J., 2012. Recursive

Macroeconomic Theory, Third Edition, MIT Press Books,
The MIT Press, edition 3, Chapter 28.
2 Merz, Monika, 1995. ”Search in the labor market and
the real business cycle,” Journal of Monetary Economics,
Elsevier, vol. 36(2), pages 269-300, November.
3 Pissarides, Christopher, (2000), Equilibrium
Unemployment Theory, Second Edition, Oxford.
4 Williamson Stephen, Notes on Labor Search

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