Exam 17: Unemployment: Causes and Consequences

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Briefly, UI can affect the incidence and duration of search unemployment by altering the costs and benefits of job search. Several cases need to be considered, depending on whether the individual is (1) employed, (2) unemployed and eligible for UI benefits, and (3) not eligible for benefits. For the employed, an increase in the benefit rate makes unemployed search more attractive relative to employed search; as a consequence, the incidence of unemployment is predicted to rise. For the unemployed who are eligible for benefits (because of a previous spell of employment), an increase in the benefit rate lowers the marginal cost of search. According to the theory of optimal search, the expected or average duration of job search will increase.
When UI benefits are exhausted, there is often a "spike" in the probability of leaving unemployment, and is often interpreted as indicating that unemployed UI recipients search mor intensively or become more likely to accept job offers as benefit exhaustion approaches.
Implicit contract explicitly explains phenomena such as rigid wages and the use of quantity adjustments (layoffs and rehires) rather than wage adjustments to respond to variations in product demand. In the case demand fluctuations, firms can temporarily lay off workers, who can claim benefits from UI program as a substitution of income loss and waiting for the recall from the firm. In this case, both firms and workers are better off under the UI system.

UI also affects employment and unemployment through its impact on labour force participation This aspect was analyzed in Chapter 3 using the income-leisure choice model as well. The analysis applies to situations in which employees can adjust their weeks of employment and nonemployment in response to the incentives inherent in the UI system. The many individuals for whom a job entails being employed throughout the year do not fit in this category. The relevant group consists of those who work less than a full year, either because the worker quits or is laid off after a certain period of employment or because the job itself is short term in nature, as is the case in much seasonal work. The first paragraph of the suggested answer showed that more generous UI will decrease weeks worked by those who, prior to the change, worked more than the minimum number of weeks required to qualify for benefits, whereas more generous UI will increase weeks of employment for those who previously did not qualify Most of the latter group would have been out of the labour force prior to the change; for these individuals, higher UI benefits make labour force participation sufficiently attractive to obtain least enough employment to qualify for benefits.

In summary, the UI system has numerous effects on labour force behaviour. A substantial amount of empirical research has been devoted to estimating the size of these effects.
Although there are some offsetting influences, the overall impact of a more generous UI benefit structure is to increase unemployment. This does not imply that improvements in UI generosity are undesirable or that changes that to some extent "tighten up" the UI program are desirable; it simply points up the fact that such changes affect our aggregate unemployment rate and that this should be considered in interpreting this statistic. More generally, the trade-offs inherent in the UI system need to be recognized in the design of UI financing and benefits. The more generous the benefit structure, the greater the insurance value of the program but also the larger the adverse incentive effects and the amount of induced unemployment. Optimal UI design must strike a balance between these social costs and benefits.