Workers in the unstable industry would have an incentive to control their unemployment duration by accepting any alternative job offers leading to an increase in earnings. Similarly, employers in the unstable industry would have an incentive to control layoffs; if they could reduce layoffs at a sufficiently low marginal cost, they would be able to attract workers from the stable industry at lower annual earnings. Layoff rates, unemployment duration, and earnings would be optimal, giber that risk-averse workers must self-insure against fluctuating income, in the sense that all agents optimize by equating the appropriate marginal costs and benefits.
The allocation of resources between the stable and unstable industries would also tend to be optimal in that the appropriate weight is given to instability and because workers must self-insure. Any exogenous reduction in the degree of volatility would lead to an expansion of the unstable industry relative to the other sector.
For comparison with the cases described in the following sections, let us suppose that the smoothly distributed annual earnings in the stable industry are $25,000, while the fluctuating earnings in the unstable industry are $26,000. The difference of $1,000 represents the cost of self-insurance.
Private Unemployment Insurance
Consider now that there is a private UI program, which can offer a constant annual income stream to workers in the unstable industry at a uniform price per employee that is less than the cost of self-insurance. An insurance company might be able to offer such a relatively cheap contract by pooling the risk of income loss both across individual workers and over time. In practice, the insurance company would have to charge premiums that might be substantial during periods of employment and then return most, but not all, of them as benefits during periods of unemployment. The administrative costs, as well as normal profits for insurance provision, are covered by the difference between total premiums and total benefit payments. Accordingly, we define two income concepts for employees in the unstable industry: gross income is the total average annual income received from the employer, while net or disposable income is the gross income plus total benefits received minus total premiums paid. Movement by workers between the two industries equals the gross income (which is identical to net income) in the stable industry.
In comparison with the case of worker self-insurance, relative labor costs have fallen in the unstable industry, so that there will be a tendency for it to expand. In other words, since risk pooling through insurance has removed part of the undesirable effects of instability, the activity in the unstable industry is likely to expand at the expense of the other.
The introduction of private insurance has given rise to two possible moral hazard problems. First, since the insurance companies pay the full salary as long as individuals remain unemployed, workers have no incentive to accept any new job if they value the leisure time afforded by being unemployed. This “free rider” situation may be avoided partially by proper policing of the insurance contract or by increasing worker participation in the insurance. Clearly, increases in such participation may be obtained through experience rating of individual workers or through benefit payments that decline with the duration of unemployment.
The second type of moral hazard arises from the behavior of employers. Employers have no incentive to increase the degree of employment smoothing because all employees already enjoy even incomes. Hence, personnel would not be prepared to give up income for employment stability. Some degree of worker participation in the insurance may, again, remove part of this moral hazard.
In terms of the previous numerical example, assume that the private insurance industry can offer insurance at a price of $500 a year. A possible long-run equilibrium may then be established by an annual average (gross and net) income of $25,300 in the stable industry and a gross average income of $25,800 in the unstable industry, of which workers pay $500 to insurance companies and retain $25,300 as net average annual income.