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Centre de recherche sur l'emploi et les

uctuations economiques (CREFE )


Center for Research on Economic Fluctuations and Employment (CREFE)
Universite du Quebec a Montreal

Cahier de recherche/Working Paper No. 54


Moral Hazard and Optimal Unemployment Insurance
in an Economy with Heterogeneous Skills 

Stephane Pallage
CREFE - Universite du Quebec a Montreal
Christian Zimmermann
CREFE - Universite du Quebec a Montreal

October 1997

||||||||||||||||||||{
Pallage: Department of Economics, UQAM, CP 8888 Succ. Centre-Ville, Montreal, QC, H3C 3P8, email:
pallage.stephane@uqam.ca.
Zimmermann: Department of Economics, UQAM, CP 8888 Succ. Centre-Ville, Montreal, QC, H3C 3P8,
email: zimmermann.christian@uqam.ca.
 This paper was presented at the University of Miami, the Institute for International Economic Studies at
Stockholm University, Universite Paris I, Universitat Bern, HEC Montreal, Concordia University and the
annual meeting of the Society for Economic Dynamics in Oxford. We would like to thank Gary Hansen and
Ayse I_ mrohoroglu for their very constructive comments on earlier versions of the paper.
Resume:
Dans cette etude, nous montrons que le risque moral joue un maigre r^ole dans la
determination de l'assurance ch^omage optimale. Dans une economie d'equilibre general
dynamique, nous trouvons que seule la presence d'un nombre tres important d'abuseurs con-
duit a une perte signi cative de generosite dans les allocations d'assurance ch^omage. Ce
resultat va a l'encontre de la litterature existante. Notre modele s'en distingue uniquement
par le fait que les agents di erent dans leurs habiletes, ce qui se traduit par des di erences
de salaires et de probabilites de ch^omage. Ces resultats peuvent avoir des consequences
importantes au vu des reformes recentes de l'assurance ch^omage.
Abstract:
In this paper, we show that in a dynamic general equilibrium economy, the presence of mo-
ral hazard need not induce large cuts in optimal unemployment insurance bene ts. We nd
that it takes a quite large proportion of "shirkers" to bend the generosity of the optimal
unemployment insurance program. This result stands in sharp contrast to the extant litera-
ture. Our key assumption is that agents are heterogeneous in skills and may di er in their
wage as well as in their transition in and out of unemployment. Our results have important
implications in the light of recent unemployment insurance reforms.

Keywords:
Unemployment Insurance, Moral Hazard, Redistribution, Dynamic General Equilibrium,
Heterogeneous Agents, Voting.
JEL classi cation: J65, E24
1 Introduction
An unemployment insurance program is a mechanism by which society protects its risk
averse members from adverse idiosyncratic employment shocks. Because society cannot
perfectly di erentiate those hit and those pretending to be hit by such shocks, the optimal
unemployment insurance [UI] is necessarily less generous than under full information. The
economic literature is unanimous on this qualitative impact of moral hazard. It remains
an open question, however, how much less generous the optimal unemployment insurance
should be under moral hazard. In other words, what are the quantitative consequences
of moral hazard? This question has a great social signi cance since, in the name of moral
hazard, many governments have recently proposed a reform of their unemployment insurance
program aiming at a reduction of expenditures.
The few quantitative studies to date all seem to agree that moral hazard matters a lot. Han-
sen & I_mrohoroglu (1992) question the opportunity of an unemployment insurance program
when a small proportion of agents can abuse the system and go undetected. Using a general
equilibrium model of the United States economy, they show that little moral hazard can
cause the optimal replacement ratio to drop dramatically. Zhang (1995) and Wang & Wil-
liamson (1996), in models with unobservable search and job-retention e orts, draw similar
conclusions.
In this paper, we question the importance of the moral hazard e ect. In previous studies,
the model is tted to the United States economy under the assumption that skills are ho-
mogeneous accross agents. Yet, in the United States people who never nished high school
account for 12% of the labor force, high school graduates represent a 61% share, while only
27% of the labor force holds a college degree.1 Furthermore, it appears that these groups
have very di erent average incomes and unemployment rates. An individual without a high
school degree earns on average 3.4 times less in the United States than a university graduate2
and is 4.3 times as likely to be jobless.1 In an economy in which agents di er in their skills
and therefore in their income and their unemployment risk, we show that UI generosity may
well be optimal even in the presence of moral hazard. For instance, when 20% of those who
shirk are successful in collecting UI bene ts, we nd that the optimal replacement ratio in
this heterogeneous environment is close to double what it would be under an homogeneous
population. Two e ects are driving this result: First, to the extent that a UI program
also serves some redistributive purpose, a generous unemployment insurance scheme may be
optimal from a utilitarian standpoint: The redistributive e ects between skill groups can
outweigh the welfare losses from cheaters. Second, even if each skill group was nancing its
own UI program, the di erences in unemployment probabilities would lead some groups to
seek higher insurance coverage.
For various levels of moral hazard, we also characterize the optimal private insurance pro-
gram and contrast its welfare implications to those of the public, cross{ nanced, program.
1 Source: Statistical Abstract of the United States, based on Current Population Survey, 1993, Bureau of
the Census.
2 Based on the Survey of Income and Program Participation for 1990 (US Bureau of the Census).

1
Moreover, since characterizing the optimal unemployment insurance, be it private or public,
is not sucient to ensure its implementation, we inquire whether this system could be the
outcome of a vote.
Our model is a dynamic general equilibrium model with indivisible labor and a storage
technology like that of Hansen & I_mrohoroglu (1992).3 Agents in our economy are categorized
along four skill types which determine their income level and the matrix of their transition
probabilities in and out of employment opportunities. They choose how much to consume,
whether to work or not if o ered a job, and how much to save from their budget. The skill is
common knowledge. However, the reason for unemployment is imperfectly monitored, and
some agents may choose to shirk by rejecting o ers.
Aside from the works of Hansen & I_mrohoroglu (1992), Zhang (1995) and Wang & Willi-
amson (1996), a good number of studies also try to assess the welfare implications of UI
programs. Following Shavell & Weiss (1979), Hopenhayn & Nicolini (1997) characterize the
unemployment insurance as an optimal contract between a risk neutral principal (the state)
minimizing cost and a risk-averse agent (the jobless worker). They determine the ecient
size of bene ts over time as a function of the unemployment spell. Their notion of eciency
being one of minimum cost, says little about the e ects of the UI program on output and
welfare in general. Their merit, however, is to be precise about the terms of the ecient
contract, while we take the contract as given.
The potential welfare gains of an unemployment insurance scheme can be of three types.
First, a UI program allows for better consumption smoothing. Second, by providing insu-
rance it can allow workers to be more selective in their job search. This in turn may lead to
better job matches. Third, it may have redistributive e ects. Part of the literature can be
divided in the way these e ects are considered. For instance, Andolfatto & Gomme (1996),
focussing on the welfare impact of smoother consumption, show that the 1971 reform of the
Canadian UI system, giving way to broader bene ts, was welfare improving. Their model,
however, is deprived of saving technologies, hence agents cannot self{insure. Such a model
is likely to over{estimate the welfare gains of a generous UI program. An empirical study by
Gruber (1994) also focussing on the consumption smoothing e ect in a model without moral
hazard, suggests that current replacement rates in the US are too high. Valdivia (1996)
nds similar results in a calibrated search model. The job{matching e ect is analyzed by
Acemoglu & Shimer (1997) who nd it non{negligeable within a search model without moral
hazard. In this paper we bring a novel focus on redistribution while also analyzing consump-
tion smoothing e ects. Our methodology does not permit us to account for the last source
of welfare gains. But the job{matching e ect would only strengthen our results.
We proceed as follows. In the coming section, we outline the model economy, that we later
parametrize to the United States economy in Section 3. We discuss our results in Section 4,
and conclude in Section 5.

3 Gomes, Greenwood, & Rebelo (1997) use a similar model, but add aggregate uncertainty since their
focus is the study of the unemployment rate over the business cycle.

2
2 The Model Economy
Our model economy is the economy of Hansen & I_mrohoroglu (1992) augmented with skill
heterogeneity. The economy is made of a continuum of in nitely{lived agents. The conti-
nuum is divided in four groups j 2 f1; : : :; 4g of invariant measure j .4 The four groups
di er by one characteristic, the level of education. This heterogeneity in population allows
us to account for the di erences in transition probabilities and income between population
groups observed in the United States.
Agents have preferences over consumption c and leisure l. One good is produced in this
economy through labor. It can be consumed or saved using a storage technology. The
quantity of that good that was saved to date represents an agent's asset m. Labor is indi-
visible. If a worker, individual i in group j works for h^ hours out of his unit{endowment of
time (lij = 1 h^ ). This worker produces yj units of output, where yj re ects his group's
productivity. Job opportunities are governed by a lottery which will be described below.5
The sequence of events and actions is as follows. Every period t, agents enter a lottery for
employment opportunities. They carry with them their savings mijt to date and a "certi cate"
of employment in the previous period (tij = 1 if a job opportunity was taken at t 1, 0
otherwise). Whoever is (not) o ered a job at t is indexed by st = e (u). The lottery is
governed by Markov transition probabilities pj (st+1jst). A person who is currently o ered a
job can choose to take it or leave it. In the latter case, he may receive unemployment bene ts
with a certain probability, itself depending on his previous state of employment, (tij ) |
that is whether he is a quitter (st = e, tij = 1, tij+1 = 0) or a searcher (st = e, tij = 0,
tij+1 = 0). Once the job opportunity lottery has given its outcome and labor decisions have
been taken, agents who work are paid yj , agents without job opportunity receive UI bene ts
and those who shirk learn if they have been successful at collecting bene ts. Given their
disposable income and their current assets, agents nally choose their level of consumption
and savings.
To sum up, each agent i in group j chooses a consumption{leisure{savings bundle (cij ; lij ; mij )
so as to maximize the following objective function:
X1
U (c ; l ) = E0 tU (cijt ; ltij )
ij ij
t=0
subject to the budget constraint:
mijt+1 + cijt = mijt + ytijd
4 In other words there are no exchanges of population between the four groups. This assumption highly
simpli es the computation of equilibrium since the distribution of agents between these groups does not
enter as a state variable.
5 Previous models of indivisible labor such as Hansen (1985), Greenwood & Hu man (1987) and Rogerson
(1988) all su ered from the drawback that in equilibrium unemployed agents were better o than workers.
Rogerson & Wright (1988) have shown that non{separable preferences prevent this from occurring. The
model developed in Hansen & I_mrohoroglu (1992) and ours use this type of preferences.

3
where, U (:; :) is a strictly concave and increasing function of consumption and leisure, yijd
stands for the agent's disposable income and his discount factor. Note that introducing an
interest payment on goods stored would not change the results, as Hansen & I_mrohoroglu
(1992) have argued.
The date t disposable income ytijd depends on the employment opportunity sijt 2 fe; ug,
the acceptance or rejection of a job o er tij+1 = f0; 1g and the eligibility to UI bene ts
ijt 2 f0; 1g:
ytijd = ytijd(sijt ; tij+1; ijt ):
Unemployment insurance is o ered by a government which collects a tax ( ) to nance
its program. A public UI program in this set{up is a pair (;  ) specifying a replacement
ratio  common to each skill group and a tax rate  . The UI policy is taken as given by
individual agents when they solve their intertemporal expected utility maximization. The
government balances its budget every period and chooses the UI program that procures
the highest average expected utility in the economy. The following agents are eligible for UI
bene ts: Every unemployed agent (s = u), that is anyone who did not receive an employment
opportunity, but also every quitter or searcher who refused a job and went undetected. The
probability not to receive bene ts (tij ) corresponds to the probability of being caught when
abusing the system. It depends on the monitoring e ort chosen by the government. We can
view this as another lottery. Since there is a one{to{one relationship between (:) and the
level of moral hazard, we will refer to (:) as an index of moral hazard.
For an agent in group j , eligibility to UI bene ts implies receiving a fraction  of a worker's
income yj in the same group. We formalize this below. Eligibility is governed by the following
binary function:
8
>
< with probability 1 if sijt = u
ij
t = 1 > with probability (0) if sijt = e; tij = 0; tij+1 = 0
:
with probability (1) if sijt = e; tij = 1; tij+1 = 0

ijt = 0 otherwise.

Hence disposable income can have three values in each group:


8
>
>
> yj (1
< j
 ) if sijt = e and tij+1 = 1
ytijd = > y (1  ) if ijt = 1
>
:0
> if ijt = 0

The problem of the agents is recursive and admits the following Bellman equation, which
will prove very useful when we compute the equilibrium. Agents take as given the UI policy.
4
As mentioned above, we assume that the government is able to select the UI policy which
procures the highest average utility in the economy. For ease of notations, we drop the time
subscript and use primes to denote future states. Call  the vector of exogenous variables {
i.e.  = (j; ;  ). Agents solve:

v(m; s; ; ) =
8
>
>
>
maxm U (m + (1  )yj m0; 1) + Ps pj (u; s0)v(m0; s0; 0; )
0 0 if s = u
>
>
>
>
> 8 9
< >
>
>
>
maxm U (m + (1  )yj m0; 1 ^h) + Ps pj (e; s0)v(m0; s0; 1; ) ;
0 0
>
>
>
>
> < =
>
>
> max > ()[max U (m + (1  )yj m0; 1) + P pj (e; s0)v(m0; s0; 0; )] > if s = e
>
>
> > m >
> > s >
: +(1  ( ))[maxm U (m m0 ; 1) + P pj (e; s0)v (m0; s0; 0; )]
0
> >
0
: ;
0
s 0

A private insurance scheme in this environment would be one such that agents in a given
skill group nance their own UI program, with the result that replacement ratios as well as
tax rates (premia) may di er accross skill groups.
In the next section, we parametrize this model to the United States economy and solve it
numerically.

3 Parametrization and computation


All parameter choices are made so that measures aggregated over skills correspond to those of
Hansen & I_mrohoroglu (1992). Using 1993 data from the Statistical Abstract of the United
States,6 we divide the US labor force into four groups according to educational attainment.
The rst or high skill group (college graduates, HS) represents 27% of the labor force, the
second (some college but no degree, MS) 26%, High School graduates (mS) 35% and people
without High School degree (LS) 12%. Mean monthly income7 for the four groups ranges
from $856 to $2,905. Unemployment rates consistently di er between the four categories
over a 10{year period: they range from 2.47% for the HS group to 10.65% for the LS group.8
Since we have no information as to di erences in the duration of unemployment, we follow
Hansen & I_mrohoroglu (1992) who estimate at 12 weeks the average time without a job o er
(unemployment duration) for all groups. Transition probabilities are determined using the
unemployment rates and duration. Normalizing aggregate income to 1, the unemployment
rate to 6% (to be consistent with Hansen & I_mrohoroglu (1992)) and choosing 6 weeks as
the period length, we have the following summary statistics:
6 Based on data from the Current Population Survey (US Bureau of the Census).
7 Based on the Survey of Income and Program Participation for 1990 (US Bureau of the Census).
8 Based on data from the Current Population Survey (US Bureau of the Census).

5
Table 1:
Skill group HS MS mS LS aggregate
measure .2691 .2606 .3514 .1189 1
income 1.6220 .8950 .7577 .4779 1
unempl. rate .0280 .0518 .0696 .1209 .06
transition probabilities
p(eje) .9856 .9727 .9623 .9224 .9681
p(uje) .0144 .0273 .0374 .0776 .0319
p(uju) .5000 .5000 .5000 .5000 .5000
p(eju) .5000 .5000 .5000 .5000 .5000

We consider the following utility function:


 1 
ij ij cij 1t  lij t 1
U (ct ; lt ) = 1 

with  = 0:67 and  = 2:5 as in Hansen & I_mrohoroglu (1992) and Kydland & Prescott
(1982). The discount factor is set to 0.995. It is very dicult to assess the extent of moral
hazard. We therefore perform our computations for a wide set of (:) values.
To solve the model, for given replacement ratio () and levels of moral hazard ((0) and
(1)), we iterate on the agents value function over a grid of state variables. Our asset space
is composed of 297 points between 0 and an upper bound that is never chosen by agents
in our computations. We x this upper bound at 8 as in Hansen & I_mrohoroglu (1992).
Other state variables include the skill group, the current job o er status and previous period
employment. Since there is no transition from one skill group to another, we can analyze
each group separately thereby reducing our state space. Once the value functions and the
corresponding optimal decision rules are found, the invariant distribution of the agents is
obtained iteratively. This is performed with an initial guess for the tax rate, which is then
veri ed given the decision rules and the invariant distribution of each skill group. When
the tax rate balances the government budget, average utility is calculated to measure social
welfare. We repeat the procedure for alternative replacement ratios. The highest average
utility is our criterion for the optimality of the unemployment insurance program.

4 Results
To test the importance of the moral hazard e ect on the generosity of the optimal unemploy-
ment insurance program, we perform a series of experiments, which we describe below. Our
benchmark, for the purpose of comparison, is an economy with homogeneous skills, similar
to Hansen & I_mrohoroglu (1992). This section is organized as follows. First, we present the
benchmark economy. Second, we describe the optimal unemployment insurance scheme in
6
an economy with heterogeneous skills. Third, we compare those results to a private insu-
rance system where the provider discriminates accross skill levels. Fourth, we quantify the
impact of moral hazard on employment. Finally, we reconsider those results with a di erent
optimality criterion, a majority vote instead of average utility.

4.1 Benchmark

The benchmark economy is an economy with homogeneous skills. We show below that
the social welfare function used by Hansen & I_mrohoroglu (1992) is extremely at in the
generosity of the UI program. Consequently, when computing the equilibrium numerically, a
small change in the convergence criterion may have dramatic e ects on the optimum. Current
technology allows us to be more precise about the convergence criterion, which explains the
di erences between our benchmark and the results of Hansen & I_mrohoroglu (1992).9
In absence of moral hazard, the optimal replacement ratio from a utilitarian point of view is
.75, which is empirically high ( rst line of Table 2). When 10% of unemployed individuals
rejecting o ers (searchers) can go undetected ((0) = :10), the optimal replacement ratio is
barely lower, which is di erent from the results of Hansen & I_mrohoroglu (1992) (second line
of Table 2). The reason for this lies in the average utility being extremely at in  around the
optimum, as shown in Figure 1. As a matter of fact, for an agent to be indi erent between
a replacement ratio of .65 and the optimum (.75) only requires an increase in consumption
smaller than .025%. Consequently, a small change in the tax rate may have a dramatic
impact on the optimum. Therefore determining the exact tax rate10 to balance the budget
is essential, but requires extensive computing technology. The dramatic drop in optimal
replacement ratio happens in our benchmark for moral hazard levels (0) between .15 and
.20 instead of .10 in the study by Hansen & I_mrohoroglu (1992).
When searchers are perfectly monitored, but potential quitters are not, moral hazard matters
much more (Table 3). Indeed, when (1) goes from 0 to .10, the optimal replacement ratio
drops sharply from .75 to .35. As quitters are more likely than unemployed agents to receive
job o ers, they have a higher propensity to forego an o er, especially as they may receive UI
bene ts if monitoring is not perfect. Finally, the fact that the pool of potential quitters is
much larger than the pool of potential searchers weighs heavily in the welfare cost of moral
hazard.

9We replicate Hansen & I_mrohoroglu (1992) with their tax rate.
10For example, Hansen & I_mrohoroglu (1992)'s optimal  with no moral hazard is .65 with a tax rate of
.040, while we nd a tax rate of .03982. Note that in cases where agents accumulate a lot of assets, we did
not perfectly replicate these authors' results. This applies only to very low 's, which are empirically rarely
observed in industrialized countries.

7
Table 2: Moral hazard on searchers only
Moral hazard (0) 0 .10 .15 .20 .25 .30 .50 1
Benchmark ^ .75 .70 .55 .25 .20 .15 .10 0
Av. Utility -.5499 -.5500 -.5504 -.5521 -.5527 -.5528 -.5534 -.5539
Hansen-I_mrohoroglu ^ .65 .35 - - - .15 .10 .05
Av. Utility -.5499 -.5511 - - - - - -.5524
Experiment 1 ^ 1 .80 .60 .45 .35 .25 .15 .05
Av. Utility -.6147 -.6169 -.6188 -.6230 -.6247 -.6260 -.6279 -.6289
Experiment 2 ^ .75 .70 .55 .25 .20 .15 .10 .05
Av. Utility -.6249 -.62492 -.6254 -.6273 -.6276 -.6280 -.6286 -.6289
Experiment 3 ^ .65 .65 .55 .35 .20 .15 .10 .05
Av. Utility -.5499 -.5499 -.5505 -.5521 -.5526 -.5529 -.5534 -.5541
Experiment 4 ^HS .65 .65 .60 .35 .20 .15 .10 0
^MS .65 .65 .60 .25 .20 .15 .10 .05
^mS .65 .65 .55 .25 .20 .20 .10 .05
^LS .65 .65 .35 .25 .20 .15 .10 .05
Av. Utility -.6253 -.6253 -.6260 -.6277 -.6281 -.6287 -.6293 -.6295

Table 3: Moral hazard on quitters only


Moral hazard (1) 0 .10 .15 .20 .25 .30 .50
Benchmark ^ .75 .35 .25 .15 .15 .10 0
Av. Utility -.5499 -.5521 -.5527 -.5531 -.5532 -.5534 -.5539
Experiment 1 ^ 1 .55 .45 .20 .15 .15 .05
Av. Utility -.6147 -.6221 -.6251 -.6266 -.6274 -.6279 -.6290

8
Figure 1:
Benchmark, moral hazard on searchers
-0.54

-0.545
Average utility

pi(0)=0
-0.55

-0.555 pi(0)=.3 pi(0)=.1

-0.56
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Replacement ratio

4.2 Optimal UI with heterogeneous skills


Turning to the case of heterogeneous skills, we perform three experiments. In a rst experi-
ment, we let the skill groups di er in both unemployment probability and income. To test
the respective role of those two dimensions of skill heterogeneity, we then run two experi-
ments where the groups di er only in one dimension. In those three experiments, all groups
jointly nance the UI program. Redistribution can later be made explicit by comparing
these results with a fourth experiment in which each group nances its own UI program.
Experiment 1: We compute the optimal replacement ratio for various levels of monitoring
on behalf of the government. The four groups di er in income and transition probabilities,
and share the nancing of the unemployment insurance. We initially focus on the case of
moral hazard on searchers only. Comparing our results to the benchmark in Table 2, we
nd that for any given level of moral hazard, the optimal replacement ratio is always higher
than the ratio in the benchmark.11 The case of no moral hazard ((0) = 0) is strikingly
more generous. Indeed, the insurance is perfect ( = 1) despite the fact that the unemployed
individuals do not need full compensation of income as they enjoy leisure in our model.12
11 One may wonder what "degree" of skill heterogeneity is required to induce sharp changes in optimal
UI. If we aggregated groups mS, MS and HS into one, thus limiting heterogeneity to two skill groups, the
optimal  in Experiment 1 would be .85 in absence of moral hazard and .40 for (0) = :20. Two groups are
therefore sucient to bring signi cantly di erent results.
12If we allowed bene ts to go above 100% of labor income in each group, the optimum would be at the
striking value of 305%. As can be seen in Figure 2, the welfare gains for the LS and mS groups of a generous
UI heavily outweigh the welfare losses for the MS and HS groups. This is due to the concavity of the
utility function. Of course, in the presence of moral hazard, such a situation cannot happen because of the
incentives to shirk.

9
Moreover, the drop in UI generosity is much smoother than in the benchmark. Three factors
may explain these results: heterogeneous income, heterogeneous transition probabilities and
redistribution. Experiments 2{4 help us understand the relative importance of each e ect.
The same results hold for economies with moral hazard on quitters only: The optimal 
is always higher than in the benchmark and it drops more smoothly with increasing moral
hazard, see Table 3. In the rest of the paper, we will focus on searchers since one might
argue it is much easier to monitor quitters than it is to monitor searchers.
Experiment 2: In this experiment, we want to evaluate how much the reduction in the
e ect of moral hazard may be accounted for by di erences in income between the four
groups. For this purpose, we recompute the optimal replacement ratios for every level of
moral hazard when all agents, regardless of their skill, earn the same salary when they work
(yj = 1 8 j ). For various levels of (0), the optimal replacement ratio is now very similar
to the benchmark, as can be seen from Table 2. The dispersion of income may therefore
matter a lot in our results. However, one should keep in mind that the UI program in this
experiment is much more generous than its replacement ratio may lead us to believe. Indeed,
the jobless agents from the lowest skill group earn more than they do in Experiment 1.13
Incidently, uniform salaries are equivalent to a form of non{linear taxation. With such taxa-
tion, the unemployment insurance does not have to be that generous given that most of
the redistribution is provided by the tax. As this tax is evidently extreme, a more realisti-
cally progressive tax would likely still leave a signi cant role for redistribution through the
unemployment insurance channel.
Experiment 3: We now verify the role of the heterogeneous transition probabilities go-
verning the employment opportunity lottery. If the four groups have the same transition
probabilities as in the benchmark but di erent incomes, we nd that for low levels of moral
hazard, the optimal replacement ratio is lower than in the benchmark, and the opposite for
high levels of moral hazard. However the di erences with the benchmark  remain small.
See Table 2 again.
To sum up, Experiment 1 and the benchmark di er in two respects: heterogeneous income
and heterogeneous transition probabilities. When we add either of these to the benchmark
economy, the results in terms of replacement ratios remain very close to the benchmark.
Only the combination of both dimensions of heterogeneity leads to the higher replacement
ratios in Experiment 1. As is shown in Figure 2 for a case without moral hazard, the welfare
of the bottom two skill groups is strongly improved by an increase in the replacement ratio,
since they have both lower income and lower transition probabilities. The same increase in 
reduces the welfare of the high skill group but comparatively less, given the concavity of the
utility function. For the remaining skill group, the e ect is ambiguous. Note that if we had
been able to discriminate between the unemployment durations of the di erent groups, it is
likely that the results of Experiment 1 would be even stronger since we suspect durations to
be longer for lower skill groups. We now control for redistribution.
13Before tax, the bene ts of the LS group in absence of moral hazard are respectively: :75  1 in Experiment
2 and 1  :4779 in Experiment 1.

10
Figure 2:
Experiment 1, no moral hazard
−1

−1.005 MS

−1.01
Normalized average utility

−1.015 HS LS

−1.02 mS

−1.025

−1.03

−1.035
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Replacement ratio

In this gure we have normalized average utilities so that -1 is the maximum in each group.

4.3 Experiment 4: A privately run insurance program


In this section, we consider an economy with the same heterogeneity in skills as above, but
deprived of redistributive means across groups. Each skill group runs its own UI program.
Results are presented in the bottom of Table 2.
In absence of moral hazard, all groups would select the same replacement ratio (.65), which
is much smaller than in Experiment 1, but comparable to the benchmark (given the atness
of the welfare criterion in this range). In the presence of moral hazard, the groups di er in
their choices. In particular, the replacement ratio responds faster to moral hazard the lower
the skill level because the tax burden grows more rapidly: There are more unemployed agents
and more potential searchers in the lower skill groups. The optimal  is almost everywhere
lower than under cross{ nancing. Thus redistribution plays a big role in the generosity of
the UI program of Experiment 1. Redistribution is the engine of generosity in this economy.
Moreover the average utility in the economy is lower than in Experiment 1 for all cases.
Hence, if such is the optimality criterion, the privately run insurance would never be selected.
In Section 4.5, we adopt a di erent criterion: majority voting. But before that, we present
some considerations on employment participation.

4.4 The impact of moral hazard on employment


Moral hazard raises a natural question: Among the skill groups in this model, does anyone
choose to reject o ers more often than the others?
11
Figure 3: Experiment 1, Employment vs. replacement ratio
pi(0)=0 pi(0)=.1
1 1

0.9 0.9

0.8 0.8

0.7 0.7

0.6 0.6
0 0.5 1 0 0.5 1

pi(0)=.3 pi(0)=.5
1 1

0.8 0.8

0.6 0.6

0.4 0.4
0 0.2 0.4 0.6 0.8 0 0.5 1

For a given level of moral hazard, each gure plots employment participation against replacement ratio for all skill groups in Experiment 1. The
curves from top to bottom represent HS, MS, mS and LS employment.

Remember that moral hazard is not the only reason why one may choose to refuse an o er
in this model. An individual with high asset holdings may nd it preferable to enjoy leisure
rather than work. Higher replacement ratios mean higher tax rates, which make leisure
less costly. Beyond a certain threshold, some people choose not to work. For Experiment
1 without moral hazard, Figure 3 (North-Western corner) shows that all skill groups start
refusing o ers at the same replacement ratio. However if all groups appear to have the same
threshold, that does not mean they stop working at the same rate. In fact, the lower the skill
level, the higher the propensity to refuse jobs (as appears from the slopes of the employment
curves). With high replacement ratios, the low skill group attains a certain level of assets
much more easily than with low replacement ratios. Since LS agents have a low expected
level of assets, they tend to use them sooner.
When some moral hazard is introduced ((0) = :1) in Experiment 1, the same holds, with
a tendency for low skill agents to start shirking at lower replacement ratios than the other
groups (Figure 3, North-East). Indeed, they are the ones bene ting most from the UI
program | they contribute little and receive large bene ts | while the others are not hurt
too much. However, for higher levels of moral hazard, no group seems to shirk more than
any other. See Figure 3 (South corners) for (0) = :3 and .5: For such levels of moral hazard,
no group can resist the temptation of shirking.
At this stage of the paper, we have characterized the optimal replacement ratio of a public and
a private UI programs under moral hazard. What if we let agents vote on these programs?
We now turn to this question.
12
Table 4:
LS (11.89%) mS (35.14%) MS (26.06%) HS (26.89%)
Vote A1: (0) = 0
Status quo (Experiment 1)  =1
Accept (Experiment 4) | | |  2 [0; 1]
Vote A2: (0) = :10
Status quo (Experiment 1)  = :80
Accept (Experiment 4) | |  2 [:5; :75]  2 [0; 1]
Vote A3: (0) = :30
Status quo (Experiment 1)  = :25
Accept (Experiment 4) | |  2 [:15; :25]  2 [0; :20+]
Median voter is MS. We have highlighted its choice.

4.5 Voting on a UI program


In this section, a UI program is chosen, not because it brings the highest average utility,
but rather because the majority of agents choose to vote for it. Evidently, the outcome of
a vote strongly depends on the status quo. We ask ourselves two questions: First, if the
status quo is a UI program resembling that of Experiment 1, would a majority of agents
vote for a private insurance system resembling that of Experiment 4? Second, if the status
quo were the private insurance system, would there be enough support for a redistributive
UI program?
We assume that the status quo is characterized by an optimal replacement ratio. To count
the votes, we compare for every skill group the average utility in each alternative. Thus we
assume that all members of a group vote the same. Indeed they have very similar objectives
compared to the other groups.14 The choice of each group is then weighted by its size.
Note that there is a one{to{one relationship between the replacement ratio and the tax rate.
Hence voters choose along a single dimension.
When it comes to privatization of the UI system, we nd that this proposal would be rejected
in absence of moral hazard (see Table 4, Vote A1). Only the high skill group (HS) are in
favor of such system, since they are strongly subsidizing the current program. If there is
some moral hazard ((0) = :1, Vote A2), the private insurance would pass provided  lies
within .5 and .75 for the MS group whatever is proposed to the others. For a higher level
of moral hazard ((0) = :3, Vote A3), this range narrows down to [.15, .25]. In Table 4,
notice that the status quo always corresponds to the optimum in Experiment 1 and therefore
changes with the moral hazard level.
14Wright (1986) has shown that even if agents are identical, those who are working are more likely to
vote di erently than those who are unemployed the lower the discount factor of agents. In our economy, the
discount factor is very close to 1, so by assuming people in one skill group vote similarly, we can still have a
reasonable approximation of the actual vote.

13
Table 5:
LS (11.89%) mS (35.14%) MS (26.06%) HS (26.89%)
Vote B1: (0) = 0
Status quo (Experiment 4)  = :65  = :65  = :65  = :65
Accept (Experiment 1)  2 [:1; 1]  2 [:25; 1]  2 [:6; 1] |
Vote B2: (0) = :1
Status quo (Experiment 4)  = :65  = :65  = :65  = :65
Accept (Experiment 1)  2 [:1; 1]  2 [:25; 1]  2 [:6; :7] |
Vote B3: (0) = :15
Status quo (Experiment 4)  = :35  = :55  = :60  = :60
Accept (Experiment 1)  2 [:1; 1]  2 [:2; :8] | |
Vote B4: (0) = :2
Status quo (Experiment 4)  = :25  = :25  = :25  = :35
Accept (Experiment 1)  2 [:05; 1]  2 [:15; :65]  2 [:25; :4] |
Vote B5: (0) = :3
Status quo (Experiment 4)  = :15  = :2  = :15  = :15
Accept (Experiment 1)  2 [:05; :65]  2 [:05; :4]  = :15 |
Median voter is MS. We have highlighted its choice.

If we analyze the vote closely, we see that the optimal replacement ratios we found with
the average utility criterion for Experiment 4 fall within the range of those in favor of
privatization.
In the hypothetical status quo characterized by a self nanced UI program, we nd that in
most cases, a redistributive system would be accepted, and a quite generous one. In Table
5, a replacement ratio of at least 60% is accepted when no moral hazard is present (Vote
B1). In one case, we nd that the redistributive system is rejected. With (0) = :15, the MS
group nds no acceptable alternative to the self nanced insurance, because they all imply
subsidies from MS (Vote B3).
Again, if we compare the two criteria, we nd that the optimal replacement ratio according
to average utility falls within the range acceptable in absence of moral hazard. This is not
the case with moral hazard.
To conclude, in the absence of moral hazard a redistributive UI is preferred to the private UI.
Voting equilibria are typically less generous than average utility optima. To illustrate this,
imagine the following situation: Moral hazard level is (0) = :1, the system is redistributive
and  = :8 (the optimum in Experiment 1). The private insurance would be accepted by vote
for any  by all groups but MS who require  to lie within [.5, .75]. Now that the private
insurance has passed, each group chooses its optimum. If a new vote were called, agents
would accept to switch back to the redistributive system, but with lower  than initially
14
( 2 [:6; :7]).

5 Conclusion
In this paper, we show that moral hazard may not be a good argument to cut unemployment
insurance bene ts drastically. In the extant literature, moral hazard is reported to exert a
large in uence on the optimal unemployment insurance. We show that this is not necessarily
the case. Acknowledging the di erences in skills within the labor force, which translate into
income and unemployment rate disparities, we nd that the unemployment insurance pro-
gram has an important social impact. Two forces are driving this conclusion: redistribution
between skill groups and a stronger urge to insure for the lower skill groups. We identify the
optimal unemployment insurance scheme from the perspective of a government maximizing
average utility. When asked whether they would vote for the optimal level of unemployment
insurance, agents in majority agree in absence of moral hazard. This is not necessarily true
in the presence of moral hazard.
Hansen & I_mrohoroglu (1992) suggested that when a small proportion of people could refuse
o ers and still collect unemployment insurance bene ts, the optimal replacement ratio had
to be extremely small. Our ndings do not support such drastic conclusions. It takes quite
a big proportion of abusers to make large cuts in bene ts optimal.

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