A NEW LOOK AT THE DIAMOND SEARCH MODEL: STOCHASTIC CYCLES AND EQUILIBRIUM SELECTION IN SEARCH EQUILIBRIUM

Abstract

We recast Diamond's search equilibrium model into that with a finite number of agents. The state of the model is described by a jump-Markov process, the transition rates of which are functions of the reservation cost, which are endogenously determined by value maximization by rational agents. The existence of stochastic fluctuations causes the fraction of the employed to move from one basin of attraction to the other with positive probabilities when the dynamics have multiple equilibria. Stochastic asymmetric cycles that arise are quite different from the cycles of the set of Diamond–Fudenberg nonlinear deterministic differential equations. By taking the number of agents to infinity, we get a limiting probability distribution over the stationary state equilibria. This provides a natural basis for equilibrium selection in models with multiple equilibria, which is new in the economic literature.