What is the link between the controversy rocking Indian Premier League (IPL) cricket and this year's Nobel prize for economics? Plenty, it would seem. In any kind of financial transaction, the effort of free market economists has been to reduce frictions. Information technology has helped and we have seen transaction costs fall. In India, for instance, brokerage rates are a prime example of how the friction of information asymmetry (neither the buyer nor the seller of stocks knew at what price the transaction happened) was destroyed once National Stock Exchange introduced transparent trading where prices on terminals are open for all to see.
A similar but much larger asymmetry exists in labour markets, where lack of information — or the informational friction between the recruit-ers and the recruited — exists. We also see its blatant abuse in the IPL auctions, where the information asymmetry ensured that only a select batch of people made bids. The question is: how far are market decisions affected by these frictions and if the product or service is a public good how should the government intervene?
Popularly known as the ‘search and match’ theory, the 2010 Sveriges Riksbank Prize in economics (popularly known as the Nobel Prize in Economics) has focussed on precisely this and has been awarded to two US economists — Peter A. Diamond of Massachusetts Institute of Technology, Dale T. Mortensen of Northwestern University — and British-Cypriot citizen Christopher A. Pissarides of London School of Economics and Political Science “for their analysis of markets with search frictions”.
What I find even more interesting is its relevance. From raw economic theory, econometrics and other isolatory ideas like hypothesis of rational expectations (the 1995 prize) or new methods to determine the value of derivatives (1997), the prize has moved, once again, to something touchable, partially human. Last year’s prize for economic governance or the 1998 prize to Amartya Sen for welfare economics are in the same direction. My favourite is the 2002 prize to Daniel Kahneman for “having integrated insights from psychological research into economic science” which has led to the creation of behavioural economics, which assumes that neither markets nor information are perfect, and psychological factors are important in consumer decisions.
The context and the timing of this year’s award are just right. Blind faith in free markets is giving way to the recognition that not all the people have all the information all the time. From the sub-prime credit crisis and the highly leveraged derivatives to the fall of Lehman Brothers and the reinvention of G20, all point to frictions that fill our world today. At last count they were only increasing — trade barriers and currency wars are just two actions where governments instead of removing frictions are creating them. They should study the Diamond-Mortensen-Pissarides model of unemployment. We must too.