Unemployment insurance : severance payments and informality in developing countries

We analyze whether the introduction or an increase of unemployment insurance (UI hereafter) beneÖts in developing countries reduces the e§ort made by unemployed workers to secure a new job in the formal sector. We adopt a comparative static approach and we consider the consequences of an increase of current UI beneÖts on unemployed workersídecision variables in this same period, i.e. we focus on an intra-temporal trade-o§, allowing us to assume away moral hazard complications. When there is no informal sector, unemployed workers may devote their time between e§ort to secure a new job in the formal sector and leisure. In the presence of an informal sector, unemployed workers may also devote time to remunerated informal activities. Consequently, the amount of e§ort devoted to secure a new (formal) job generates an opportunity cost, which ceteris paribus, reduces the amount of time devoted to remunerated activities in the informal sector. We show that in the presence of an informal sector, an increase of current UI beneÖts decreases this marginal opportunity cost and therefore unambiguously increases the e§ort undertaken to secure a new job in the formal sector. This intra-temporal e§ect is the only one at play in presence of one-shot UI beneÖts or with severance payments mechanism.

Unemployment insurance in the presence of an informal sector

We study the effect of UI benefits in a typical developing country where the informal sector is sizeable and persistent. In a partial equilibrium environment, ruling out the macroeconomic consequences of UI benefits, we characterize the stationary equilibrium of an economy where policyholders may be employed in the formal sector, short-run unemployed receiving UI benefits or long-run unemployed without UI benefits. We perform comparative static exercises to understand how UI benefits affect unemployed worker´s effort to secure a formal job, their labor supply in the informal sector and leisure time. Our model reveals that an increase in UI benefits generates two opposing effects for the short-run unemployed. First, since search efforts cannot be monitored it generates moral hazard behaviours that lower effort. Second, it generates an income effect as it reduces the marginal cost of searching for a formal job and increases effort.The overall effect is ambiguous and depends on the relative strength of these two effects. Additionally, we show that an increase in UI benefits increases the efforts of long-run unemployed workers. We provide a simple simulation exercise which suggests that the income effect pointed out is not necessarily of second-order importance in comparison with moral hazard strength. This result softens the widespread opinion, usually based on the microeconomic/partial equilibrium argument that the presence of dual labor markets is an obstacle to providing UI in developing countries.