1Moral Hazard, Adverse Moral Hazard, Adverse Selection and Unemployment Selection and Unemployment InsuranceInsurancePlanPlan4Examples of adverse selection: – Risk of Selling a Life Annuity– Lemons Market4Moral Hazard4A simple job search model4Unemployment Insurance– The structure– Effects on unemployment duration, layoffs, unemployment rate Risks of Selling a Life AnnuityRisks of Selling a Life Annuitycited from Neil Bruce “Public Finance and the American Economy”4 “In 1965, 47-year-old Andre Francois Raffray agreed to pay 90-year-old Jeanne Calment 2,500 francs (about $500) a month until she died, in exchange for her apartment in Arles, France”....4 Time passed...4 “In December 1995, M. Raffray died at 77 having paid $184,000 over 30 years... <worth $300,00 with 6% interest over the years... At that time,> Mme. Calment was still healthy and living in the apartment.”4 She died two years later, on August 4, 1997.2““The Market for `Lemons`”The Market for `Lemons`”(George Akerlof 1970)(George Akerlof 1970)4Used cars are substantially cheaper than new cars. Why?4 A car can be either a “plum” ($11,000) or a “lemon” ($1,000). The owner of a car knows its quality which is unobservable to potential buyers. Assume that, at first, half of the cars in the market are plums and the other half are the lemons. What is the price that a potential buyer is ready to pay? 4 Will the owners of the plums want to sell for this price? What will it imply about the quality and the resulting price of the used cars for sale?What do the two previous What do the two previous examples have in common? examples have in common? 4two parties interact4one of the parties is better informed than the other4this information has a direct implication on the payoffs that the parties receive from a potential contract between themAdverse SelectionAdverse Selection4The uninformed side should expect an “average” payoff.4Given this, only the “adverse” types will want to “sign” a contract.3An Implication for An Implication for Unemployment InsuranceUnemployment Insurance4Assume a private firm is offering unemployment insurance and buying the insurance is not compulsory.4What result would you expect?Moral Hazard, examplesMoral Hazard, examples4If you insure your car against a theft, there is no reason to lock the car.4If you are paid a fixed wage and there is no risk of being laid-off, there is no reason to work “hard”4If you get sufficiently high unemployment compensation for an indefinite future, there is no reason to look for a job.Moral HazardMoral Hazard4two parties involved in a contractual relationship4the unobserved actions of one party affect the payoff (utility) of both4the parties have opposite interests4the informed party chooses “hazardous” actions to the the uninformed party4Unemployment Compensation, Unemployment Compensation, Adverse Selection, Moral HazardAdverse Selection, Moral Hazard4Adverse Selection provides grounds for making the Unemployment Insurance compulsory.4Moral Hazard restricts the unemployment compensation schemes that can be used.Simple Job Search ModelSimple Job Search Model4Assume a worker, who discounts future income at a rate gets unemployment compensation b>0 and is looking for a job.4He gets job offers w that are drawn from a probability distribution F(w).4If the worker accepts, he is employed forever.4What is the relationship between the lowest wage that he will accept and the unemployment compensation?βThe Job Search ModelThe Job Search Model4Denote by v(w) the expected value of life time earnings for a worker who has an offer w4If the worker accepts the offer, he receives wforever, 4If he rejects the offer, he gets the unemployment benefit b this week and waits till the next period to get another offer, the expected value of which is ( )∑−==∞=1 1ttwwwvββ()()∫''wdFwv5The Job Search ModelThe Job Search Model4The person’s maximization problem is then( ) ( )+−=∫'',1max dFwwvbwwv ββ()∫+ '' dFwwvb βwwv()wv()β−1/1reject offersaccept offersThe lowest acceptable wage and The lowest acceptable wage and unemployment compensationunemployment compensation4The reservation wage (the lowest acceptable wage) is determined as follows:( ) ( )∫−−=−∞wdFwwwbw ''11βwwbw−b−Ewββ−1( )∫−−∞wdFwww ''1 ββ↑↑⇒wbUnemployment Insurance in Unemployment Insurance in the U. S.the U. S.4 The Social Security Act of 1935 and the Federal Unemployment Act of 1939 created a program for unemployment compensation.4 Federal government provides the minimum standards, state governments administer the program.4 Beneficiaries: – must be laid-off (involuntary)– must be ready to work if offered “suitable” employment (workers customary occupation)– can not be new entrants and re-entrants to the labor force– had to earn a minimum amount in the previous year– had to be employed at least (two or more) quarters– get the compensation for a limited period6FinancingFinancing4Part of the payroll tax (levied on employers) go into the Unemployment Trust Fund.4Federal government can levy 6.2% tax on the base ($7,000) yearly salary of a covered employee. 5.4% is credited to the states. Some states levy additional taxes (over 5.4%), moreover the base salary may be higher than the federal standard, it differs from state to state.Differences in the Coverage by Differences in the Coverage by State State 19951995--1996 data1996 data4 Previous (yearly) earnings requirement: – $130 in Hawaii– $4280 in Oklahoma4 Lowest minimum weekly benefit – $5 in Hawaii– $75 in Washington State4 Average weekly benefit: National ave was $179– $119 in Louisiana– $262 in HawaiiDifferences in the Coverage by Differences in the Coverage by State (1995), ContinuedState (1995), Continued4 Gross replacement rate=Compensation/gross ave wages 36.3%– 26.8% in Louisiana– 45.3% in Rhode Island– Note, however, that the wages of unemployed are usually lower than the average wages, thus the effective (for the unemployed) gross replacement rate is higher. In general, the weekly benefitreplaces over a half of the claimants income.4 Length is maximum 26 weeks except for MA and WA:304 Average length: Nationwide 15 weeks– 9 weeks in North Carolina– 20 weeks in New York7Unemployment Duration and Unemployment Duration and Unemployment Benefit Unemployment Benefit Meyer, Bruce “Unemployment Insurance and