Question

Relying on ideas of consumption smoothing and moral hazard, explain how the benefits and costs of unemployment insurance are related to the duration of unemployment.

Answer 1

It is true that unemployment insurance (UI) benefits affect search behavior and develops a simple method
of calculating the welfare gains from UI using this evidence. I show that 60 percent of the increase in unemployment durations caused by UI benefits is due to a “liquidity effect” rather than distortions on
marginal incentives to search (“moral hazard”) by combining two empirical strategies. First, we find that increases in benefits have much larger effects on durations for liquidity-constrained households. Second,lump-sum severance payments increase durations substantially among constrained households. we have a formula for the optimal
benefit level that depends only on the reduced-form liquidity and moral hazard elasticities. The formula implies that the optimal UI benefit level exceeds 50 percent of the wage. The “exact identification”approach to welfare analysis proposed here yields robust optimal policyresults because it does not require structural estimation of
primitives.

The Consumption Smoothing Benefits of Unemployment Insurance” AER 1997 are as follows below:

1.Need estimate of Δc/cfor optimal UI formula
2.More generally Gruber is interested in evaluating the benefits of social programs.

Moral Hazard in Unemployment
UI leads to classic moral hazard outcome—Increased likelihood of insured
event (unemployment)
• “Inflow” to Unemployment
1.Compensation while unemployed makes jobs with high unemployment
more attractive (relatively)
2.Employers more likely to layoff workers since they will be compensated
while they are unemployed. (Experience rating of UI complicates this)
• “Outflow” from Unemployment (duration of unemployment)
1.For workers, the cost of being unemployed has fall since they collect UI
benefits. Both income + substitution effects imply that duration of
unemployment spell will rise due to UI.
2.UI results in more inc which results in more leisure.
3.UI results results in leisure decreases which means more leisure.

UI affect duration of unemployment? (Mortenson 1977 ILRR)
Basic Search Model
Maximize pdv of expected utility
U = U(Y, L)
Stationary, known offer wage distribution
Arrival rate of jobs offers is constant over time given search intensity
Effort put towards search is a choice variable (e.g. less leisure)
¾takes effort (search) to get opportunity to draw from offer wage distribution
¾If wage > WR (reservation wage)
⇒ take job and unemployment ends
Pr(W > WR) = 1 – Pr(W < WR) = 1 – F(WR)