The Optimal Dole with Risk Aversion and Job Destruction

Upjohn Institute Staff Working Paper 97-47

Carl Davidson and Stephen Woodbury

January 1997

Revised February 1998

Abstract

This paper extends earlier research on optimal unemployment insurance (UI) by developing an equilibrium search model that encompasses simultaneously several theoretical and institutional features that have been treated one-by-one (or not at all) in previous discussions of optimal UI. In particular, the model we develop allows us to determine the optimal potential duration of UI benefits as well as the optimal UI benefit amount; assumes (realistically) that not all workers are eligible for UI benefits; allows examination of various degrees of risk aversion by workers; models labor demand so that the job destruction effects of UI are taken into account; and treats workers as heterogeneous. The model suggests that the current statutory replacement rate of 50 percent provided by most states in the United States is close to optimal, but that the current potential duration of benefits (which is usually 26 weeks) is probably too short. This basic result--that the optimal UI system is characterized by a fairly low replacement rate and a long potential duration-- conflicts with most of the existing literature on optimal UI. We argue, however, that the result is consistent with a large literature on optimal insurance contracts in the presence of moral hazard.

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