In spite of the persuasive arguments for this insurance, private UI markets have been very limited. Many reasons for this apparent market failure have been adduced. For instance, Rosen (1977) and Topel and Welch (1980) ascribe the deficiency to the high concentration of claims during recessions, which inhibits risk pooling among workers. Whatever the reason, all industrialized societies have seen fit to introduce public UI systems. In general, these systems are financed out of general government revenue or by a uniform payroll tax. Only rarely are taxe, imposed on the individual insurants, namely, the workers.
As stated earlier, the UI system in the United States is unique in that it is financed by a payroll tax assessed on and experience rated for individual employers. Thus, employers owe higher taxes when the unemployment benefits paid to their laid-off employees are larger. Details of the two most common methods of experience rating are presented later in this chapter.
Simple Analytical Model of Unemployment Insurance
To illustrate the major consequences of experience rating in unemployment insurance, we postulate a simple model that preserves the essential elements of the various arguments. Assume that there are two competitive industries, which are identical in all relevant respects except that one is stable and one is unstable. The stable industry faces a non fluctuating demand, whereas the unstable industry is subject to recurrent demand swings that may be fairly regular (cyclical or seasonal) or random. Further, within the unstable industry, the demand fluctuations are distributed randomly across individual employers. In the short run, those employers are not affected identically by the variability in industry demand, but over a suitably long period of time, all employers in the unstable industry experience the same average fluctuations. Employers have the ability to mitigate the impact of swings in demand upon layoffs by means of production smoothing and similar techniques, which have marginal costs. Employers balance these costs against the costs of layoffs and rehires and thus determine their optimal layoff rates.
We assume that the total labor supply for the entire economy is not responsive to wage changes (that is, it is perfectly inelastic), although workers can move between the two industries, All worker are assumed to be homogeneous in the relevant characteristics, and, in particular, to have identical degrees of risk aversion, Movements of workers between industries are sufficiently responsive so that, in the long run, the net compensation of employees is equalized in the two sectors. Layoffs are affected by employers, without influence by workers and are distributed randomly across employees. Workers may have the ability to control the duration of unemployment, however, by accepting or rejecting new job offers. All of these assumptions can be relaxed without affecting the essential results of the following arguments.
We analyze this simple model under four different sets of circumstances. First, there is no formal UI system, so that employees must self-insure. This means that workers in the unstable industry must provide for their own income maintenance during periods of unemployment, by saving and/or borrowing. Second, there is private UI financed by premiums charged to individual workers. Third, there is public UI financed by a uniform employer tax. For the sake of simplicity, we assume that all UI programs are complete, in the sense that they smooth out completely the income fluctuations caused by layoffs.
