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Working Papers

June 2009, No. 09-9

Unemployment Insurance with a Hidden Labor Market

Fernando Álvarez-Parra and Juan M. Sanchez

This paper considers the problem of optimal unemployment insurance (UI) in arepeated moral hazard framework. Unlike existing literature, unemployed individualscan secretly participate in a hidden labor market. This extension modifies the standardproblem in three dimensions. First, it imposes an endogenous lower bound for thelifetime utility that a contract can deliver. Second, it breaks the identity betweenunemployment payments and consumption. And third, it hardens the encouragementof search effort. The optimal unemployment insurance system in an economy with ahidden labor market is simple, with an initial phase in which payments are relativelyflat during unemployment and with no payments for long-term unemployed individuals.This scheme differs substantially from the one prescribed without a hidden labor marketand resembles unemployment protection programs in many countries.

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