CU-Boulder ECON 4211 - Moral Hazard, Adverse Selection and Unemployment Insurance (7 pages)

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Moral Hazard, Adverse Selection and Unemployment Insurance



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Moral Hazard, Adverse Selection and Unemployment Insurance

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Pages:
7
School:
University of Colorado at Boulder
Course:
Econ 4211 - Economics of the Public Sector
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Moral Hazard Adverse Selection and Unemployment Insurance Plan 4 Examples of adverse selection Risk of Selling a Life Annuity Lemons Market 4 Moral Hazard 4 A simple job search model 4 Unemployment Insurance The structure Effects on unemployment duration layoffs unemployment rate Risks of Selling a Life Annuity cited 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 1 The Market for Lemons George Akerlof 1970 4 Used 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 examples have in common 4 two parties interact 4 one of the parties is better informed than the other 4 this information has a direct implication on the payoffs that the parties receive from a potential contract between them Adverse Selection 4 The uninformed side should expect an average payoff 4 Given this only the adverse types will want to sign a contract 2 An Implication for Unemployment Insurance 4 Assume a private firm is offering unemployment insurance and buying the insurance is not compulsory 4 What result would you expect Moral Hazard examples 4 If you insure your car against a theft there is no reason to lock the car 4 If you are paid a fixed wage and there is no risk of being laid off there is no reason to work hard 4 If you get sufficiently high unemployment compensation for an indefinite future there is no reason to look for a job Moral Hazard 4 two parties involved in a contractual relationship 4 the unobserved actions of one party affect the payoff utility of both 4 the parties have opposite interests 4 the informed party chooses hazardous actions to the the uninformed party 3 Unemployment Compensation Adverse Selection Moral Hazard 4 Adverse Selection provides grounds for making the Unemployment Insurance compulsory 4 Moral Hazard restricts the unemployment compensation schemes that can be used Simple Job Search Model 4 Assume a worker who discounts future income at a rate gets unemployment compensation b 0 and is looking for a job 4 He gets job offers w that are drawn from a probability distribution F w 4 If the worker accepts he is employed forever 4 What is the relationship between the lowest wage that he will accept and the unemployment compensation The Job Search Model 4 Denote by v w the expected value of life time earnings for a worker who has an offer w 4 If the worker accepts the offer he receives w w forever v w t w t 1 1 4 If 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 v w dF w 4 The Job Search Model 4 The person s maximization problem is then w v w max b v w dFw 1 v v w b v w dFw 1 1 reject offers w w accept offers The lowest acceptable wage and unemployment compensation 4 The reservation wage the lowest acceptable wage is determined as follows w b Ew 1 b 1 w w dFw 1 w w b w w dFw 1 w w w b w Unemployment Insurance in 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 period 5 Financing 4 Part of the payroll tax levied on employers go into the Unemployment Trust Fund 4 Federal 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 State 1995 1996 data 1995 4 Previous yearly earnings requirement 130 in Hawaii 4280 in Oklahoma 4 Lowest minimum weekly benefit 5 in Hawaii 75 in Washington State 4 Average weekly benefit National ave was 179 119 in Louisiana 262 in Hawaii Differences in the Coverage by State 1995 Continued 4 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 benefit replaces over a half of the claimants income 4 Length is maximum 26 weeks except for MA and WA 30 4 Average length Nationwide 15 weeks 9 weeks in North Carolina 20 weeks in New York 6 Unemployment Duration and Unemployment Benefit Meyer Bruce Unemployment Insurance and Unemployment Spells Econometrica 58 1990 pp 757Econometrica pp 757 782 4 Empirical Findings higher benefits reduce probability that insured unemployed workers will leave unemployment the probability is measured as a ratio of newly employed workers at the end of the week to those unemployed at the beginning of the week 10 increase in the benefits decreases this probability by 5 3 percentage of workers finding employment rises in the last week when the compensation is paid Unemployment Compensation and Layoffs 4 Firms may decide to lay off workers when the business is slow 4 There are implicit and explicit costs to layoffs job specific knowledge of the workers is lost recruiting new workers is consuming resources if the job is viewed as insecure workers will require higher wages 4 UC reduces the last cost thus firms will layoff more the better is the UC How to avoid subsidizing layoffs 4 Experience rating recall that the tax is imposed on employers some


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