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Optimal Unemployment Insurance in Labor Market Equilibrium when Workers can Self-Insure

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Author Info
Reichling, Felix

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Abstract

I develop an equilibrium matching model in which workers have preferences over consumption and hours of work and are able to self-insure against unemployment risks by accumulating precautionary wealth. Wages and working hours are the outcomes of Nash bargaining between workers and firms. I focus on an unemployment insurance (UI) system with constant benefits of indefinite duration financed through a constant labor income tax. Low-wealth individuals work unusually long hours to quickly accumulate precautionary wealth. The Frisch elasticity of labor supply governs a worker’s utility cost of supplying labor and hence the cost of accumulating precautionary wealth. A lower elasticity implies a higher utility cost of adjusting hours. I take Frisch elasticities from recent research using household data and find that the optimal level of UI benefits is between 34 and 40 percent of average compensation. The potential welfare gains from moving from current 34 percent to the optimal policy are as large as 0.13 percent of lifetime consumption. The optimal replacement rate is decreasing in the Frisch elasticity of labor supply.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 5362.

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Date of creation: 06 Nov 2006
Date of revision: 16 Oct 2007
Handle: RePEc:pra:mprapa:5362

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Related research
Keywords: Unemployment insurance Labor supply Matching equilibrium Self-insurance

Find related papers by JEL classification:
J22 - Labor and Demographic Economics - - Demand and Supply of Labor - - - Time Allocation and Labor Supply
H00 - Public Economics - - General - - - General
J65 - Labor and Demographic Economics - - Mobility, Unemployment, and Vacancies - - - Unemployment Insurance; Severance Pay; Plant Closings
E24 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment - - - Employment; Unemployment; Wages; Intergenerational Income Distribution

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