Labour Economics

1
Labour Economics

• Dr Hamish Low
• Lecture 6
• (Office Hour Wed 24th 11.45 1.15pm)

2
Outline

• Costs and benefits of unemployment insurance
• Bailey model saving and search
• Imperfect capital markets
• In-work benefits

3
Benefits and Costs of UI
4
Tradeoffs

• The traditional way to think about the moral
  hazard in unemployment is with search models
  (Mortensen 1977)
• Income maximization (linear utility) implies no
  consumption smoothing benefits
• UI can have benefits in a linear utility
  (equilibrium) search model (eg. if there is an
  externality from search) but its not obvious
  this is the central issue.
• Want model where consumption smoothing matters,
  but moral hazard also arises

5
Bailey (1978)
Possible Job loss

No job loss
wage
Saving against job loss
consumption
w with UI
Job loss occurs
T
Search

• Consumption falls on job loss.
• Utility loss from consumption partially smoothed
  over states by UI and by saving

• Unemployment insurance increases search.

6
Time Path of Earnings
I
T2
0
T1
7
Euler equation
Imperfect smoothing over states
8
Value of Unemployment Insurance

• Improves smoothing over states, but induces some
  inefficiency
• Gruber (1997)
• becoming unemployed associated with 6.8 drop in
  (food) consumption
• if no UI, drop in consumption would be 22.2
• 10 increase in replacement ratio, reduces fall
  in consumption by 2.65

9

• Hansen and Imrohoroglu (1992)
• no moral hazard in search
• optimal replacement ratio of 0.65
• with moral hazard
• optimal replacement ratio of 0.15
• welfare cost of unemployment 0.67

10
Imperfect Capital Markets

• In Bailey and in standard search models,
  indifferent to the timing of income after job
  loss (perfect credit markets?)
• What if unemployed are unable to borrow against
  future earnings?
• after job loss, two stages search stage and
  earnings stage. May be unable to smooth
  consumption (and marginal utility) over these
  stages

• affects incentives to accept a job
• a job offer appears more valuable because
  increases current consumption, so lower
  reservation wage

11
Simulated Durations
How long to search for higher wage after becoming
unemployed?
Duration
credit constrained
0.9
unconstrained
0.7
optimal duration
0.5
0.3
b
0.2
0.4
0.6
Unemployment benefit
Are individuals choosing durations that are too
short or too long relative to optimal (income
maximising)?
12
Optimal replacement rate
Age at job loss
13
In-Work Benefits
Net Income,
Single-Child Household, One earner at min wage
25000
20000
with tax credits
15000
10000
Income tax and income support
5000
5000
10000
15000
20000
25000
Gross Income,
14
In-Work Benefits
Net Income,
Single-Child Household, One earner at min wage
25000
20000
with tax credits
15000
10000
Income tax and income support
5000
5000
10000
15000
20000
25000
Gross Income,
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17
Reservation Wage

• Static decision (income maximisation)

income if return to work
gross income
unemployment insurance
child care cost of work
tax credit (-ve if net tax payer)
18

• Dynamic decision (returns to search)

increase in lifetime income if keep searching
increase in lifetime income if return to work
gross income
unemployment insurance
child care cost of work
tax credit (-ve if net tax payer)
increase in lifetime earnings from better job
match / training
Effect of t tax credit lowers wres
19
with credit constraints
How long to search for higher wage after becoming
unemployed?
Duration
unconstrained tax credit
unconstrained, no tax credit
0.9
constrained tax credit
0.7
optimal duration
0.5
0.3
b
0.2
0.4
0.6
Unemployment benefit
20
Implications

• Are unemployment durations too long or too short
  in absence of intervention?
• no credit constraints durations may be too long
• with credit constraints durations may be too
  short
• Subsidise search or offer tax credits?
• Analogy to market failures in education? Using
  loans avoids identifying source of wage growth?

21
Conclusions

• Unemployment insurance has risk-sharing benefits,
  but increases reservation wage and reduces effort
  in job search
• UI crowds out private saving only partial
  insurance
• If credit constrained UI helps consumption
  smoothing and moral hazard effect may be less
  (higher optimal UI)
• In-work benefits are durations too long or too
  short?