Optimal unemployment insurance: a survey.

• Author: Karni, Edi

1. Introduction

   Unemployment insurance (UI) programs vary across countries and over time in terms of eligibility for benefits, their size and duration, and methods of financing.(1) Eligibility for UI benefits may depend on employment history, the immediate reason for becoming unemployed, efforts made to secure new employment, and record of refusal to accept suitable job offers. The size of the benefits may depend on the unemployed past earnings and the duration of the current spell of unemployment. The duration of UI benefits may be limited or not. The program may be financed by one or more of the following methods: contributions of employers, contributions of employees, or general tax revenue.

   Presumably, these variations reflect attempts to balance the benefit of more efficient allocation of the unemployment risk and the cost of reduced work incentives and other distortions associated with UI insurance. It is, therefore, not surprising that much of the theoretical and empirical research on UI aimed at identifying and assessing the magnitude of its various incentive effects and their impact on unemployment and wages. At the same time, some of the research effort is concerned with the design of optimal UI programs. The purpose of the present paper is to review the literature on optimal UI insurance, to assess its accomplishments, and to point out relevant issues that require further study. The objective limits the scope of this review. In particular, I shall not attempt to survey the vast literature dealing with positive aspects on UI.

   Unemployment Risk

   The demarcation line between UI and other social insurance programs is not always clear. In this paper, UI is taken literally to include only programs designed to indemnify the unemployed for loss of income resulting from the loss of employment. It is important to recognize that not every kind of loss of employment constitutes an insurable risk. The principle used to guide the definition of unemployment risk is the extent to which the loss of employment - and, consequently, of income - is due to circumstances that are, by and large, beyond the control of the employee.

   An employee may become unemployed by quitting a job voluntarily, by being fired for industrial misconduct or unsatisfactory job performance, or as a result of adjustments in employment required by business considerations of the firm in which he is employed. Quitting voluntarily or being fired for industrial misconduct are within the control of the employee and, consequently, do not qualify as unemployment risk. Unsatisfactory job performance is a source of unemployment risk, although in practice it is difficult to distinguish from shirking; job performance may be subject to manipulation by employees. Variations in employment that are due to business considerations may be a response to the introduction of labor-saving technologies, to reorganization of the firm's operations, or to reduced demand for the firm's output. Note, however, that predictable demand variations, such as seasonal variations in employment of agricultural workers, do not require UI. In other words, when variations in income and employment are regular and predictable, the consumption smoothing is better handled by saving and borrowing. I shall elaborate on the role of saving as a mean of self-insurance against income variations. At this point, it suffices to observe that the disadvantage of savings is that it does not represent a contingent claim on future consumption. However, if future income is predictable, the contingency aspect is insignificant. Thus, only unanticipated variations in employment, whether temporary or permanent because of demand shifts or any other reason, justify institution of UI.

   Preliminary Observations

   The literature on optimal UI is relatively new. Its development during the past two decades have been influenced by ideas and methods from two main fields of research: labor economics and economics of information.

   From labor economics, it borrowed models describing the search behavior of the unemployed as well as job-matching models of the labor market. The job search models depict the behavior of the unemployed in terms of an optimal stopping rule in environments in which information concerning job offers appears sequentially and the decision at each stage is whether to accept a current job offer or to reject the offer and continue the search.(2) The job-matching models introduce general equilibrium considerations, according to which the success of the search effort depends on the relative number of vacancies and job seekers.

   Developments in the economics of information, especially advances in the theory of incentive contracts, had a decisive influence on the analysis of optimal UI schemes. Somewhat less pronounced was the influence of ideas about incentive compatibility constraints and equilibrium concepts introduced to model markets plagued by adverse selection problems.

   Some studies of UI take the wage rate (wage distribution) as given, thereby disregarding the macroeconomic consequences of UI, whereas in other studies, the equilibrium wage rate is determined jointly with the parameters of the optimal UI program. Moreover, the notion of optimality itself is not uniform across studies. In some studies, the criterion for evaluating alternative UI schemes is minimizing the cost of UI subject to the condition that it attains a minimum level of expected utility of the participating individuals. Other studies use the criterion of Pareto optimality, appropriately defined for environments characterized by asymmetric information. For some purposes, the former approach entails no essential loss of generality, especially if the economy is assumed to be populated by individuals who, for the purpose of UI, are identical. In general, however, the second approach is preferable because it implies minimizing the cost of UI and is capable of dealing with the choice of the level of expected utility of diverse groups.

   Asymmetric Information

   Moral hazard and adverse selection problems impede the effectiveness of social insurance programs in general and of UI in particular.(3) Hence, any attempt to tackle the problem of the design of optimal UI must begin by identifying and characterizing potential sources of private information pertaining to hidden actions and hidden characteristics that give rise to problems of moral hazard, adverse selection, and fraud.

   Two kinds of hidden actions may give rise to moral hazard problems in UI. First, the effort, time, and money the unemployed person expends to secure new employment and his implicit willingness to accept specific job offers are hidden actions that influence the duration of the unemployment spell and the UI compensation. Second, the effort employees exert performing their jobs is hidden action that affects the probability of transition into the state of unemployment. From the viewpoint of UI, shirking may be classified as industrial misconduct. Consequently, if the unemployment is a direct result of shirking, the dismissed employee is not entitled to UI. It seems, therefore, that shirking is not a problem. In practice, however, it may be difficult to distinguish shirking from incompetence and to attribute a low level of performance to voluntary behavior on the part of the employee. Thus, the probability of transition to a state of covered unemployment is to some degree subject to manipulation by the employee and cannot be dismissed a priori as a source of moral hazard. Having said that, I should add that this issue has not been studied empirically; therefore, its empirical importance is not clear. The literature on incentive contracts suggests that this problem of motivating employees is dealt with by the wage contract. Hence, from the viewpoint of optimal UI, the main issue is the effect of alternative UI designs on resource allocation in the presence of incentive wage contracts. The issue of incentive contracts also arises with regard to the behavior of the unemployed. Here, however, UI is the incentive contract. Not surprisingly, therefore, most of the literature on optimal UI has focused on this latter issue.

   Two kinds of hidden characteristics may give rise to adverse selection problems in UI.(4) First, employees differ in terms of their preferences for leisure (or, more generally, nonmarket employment of their time). These differences reflect the personalities of the workers as well as the nonmarket opportunities they face, which may be difficult if not impossible to monitor. At one extreme are individuals who would rather work, even if the replacement ratio offered as UI benefit is 100%, because they derive psychic pleasure (fulfillment) from their work. At the other extreme are individuals who would rather be unemployed even without UI benefits. After having a baby, for example, a new parent may decide to stay home regardless of whether he or she is covered by UI.

   A second source of private information that may give rise to adverse selection is firm-specific risk. Each firm or industry is subject to demand variations or technological changes that bear upon future employment prospects. These changes become apparent to insiders, including management and employees, long before they are perceived by outsiders, including the provider of UI. For instance, insiders may observe well in advance of outsiders that insufficient orders or plans to install new equipment are likely to result in work force redundancy and eventual unemployment. Employees who find themselves in this kind of situation are more inclined to take out UI.

   In the context of UI, the different characteristics of either firms or individuals interact with their actions, producing an effect that tends to exacerbate the problem of adverse selection. This effect, termed endogenous adverse selection by Chiu and Karni (1998), is the result of imperfect experience rating. To grasp this notion, suppose...