On the functioning of markets with frictions

Economic activity in labor, goods and housing markets varies substantially over time. The number of unemployed workers, unfilled vacancies, unsold inventories, or houses for sale can easily double in the course of a few years. Similarly, at one moment finding a job or selling a house can take a couple of days, while at another moment either can take more than two years. Search frictions provide an explanation for the coexistence of unemployed workers and unfilled vacancies. Because search frictions result in trading delays, they can also help us understand time-on-market and how this can vary over time. Finally, search frictions make the occurrence of trade risky and dependent on the actions of others. Indeed, markets with search frictions are generally characterized by externalities. When the optimal strategy of one agent increases in the strategies of others, strategic complementarities arise. In such situations, agents have incentives to coordinate their actions and to behave in similar ways. This thesis proposes strategic complementarities as explanation for market volatility in labor and housing markets. It explains the observed cycles in unemployment and vacancies, as well as the dynamics of housing prices, the stock of houses for sale, housing transactions, and time-on-market. Furthermore, this thesis explains the co-existence of self- and payroll employment as resulting from frictions in goods markets. Finally, it shows that there is a role for institutions such as unemployment insurance to improve the functioning of markets with frictions, and that these institutions can simultaneously increase equity and efficiency.