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Adverse Selection and Moral Hazard: Quanitative Implications for Unemployment Insurance

  • David Fuller

    (University of Iowa)

I construct a dynamic contracting model of optimal unemployment insurance with adverse selection and moral hazard. The interaction of the two informational frictions generates novel qualitative and quantitative implications for the provision of unemployment insurance. Qualitatively, for certain agents, incentives in the optimal contract imply expected consumption may actually increase over the duration of unemployment. Quantitatively, the optimal contract reduces costs by over 100%, relative to a stylized version of the current U.S. unemployment insurance system. Compared to a planner who ignores adverse selection and focuses only on moral hazard, the optimal contract achieves an additional 47% of cost savings. Of the extra savings, around 3.2% arises from improved incentives to exert effort, leading to higher expected output. A more efficient allocation of consumption explains the remaining portion of the additional cost savings.

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Paper provided by Society for Economic Dynamics in its series 2008 Meeting Papers with number 889.

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Date of creation: 2008
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Handle: RePEc:red:sed008:889
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

Web page: http://www.EconomicDynamics.org/society.htm
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  1. Marcus Hagedorn & Ashok Kaul, 2004. "An Adverse Selection Model of Optimal Unemployment Insurance," 2004 Meeting Papers 331, Society for Economic Dynamics.
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