In , we described the flow of workers between situations of employment, unemployment, and out of the labor force. We also argued that having a flexible labor market in which people can change jobs easily may more than compensate for the fact that people may sometimes spend time in unemployment.
But this is abstract economist-speak. People who lose their jobs, even if only temporarily, see their livelihood vanish. The reallocations of jobs that are beneficial to the economy as a whole may be costly, even devastating, to the affected individuals. For this reason, most developed economies have some kind of unemployment insurance to protect their workers. Unemployment insurance means that, if you are unemployed, you will receive some income from the government. Exactly how long you receive this income for and exactly how much you get depends on where you live. Some countries have much more generous unemployment insurance than others. Even if you live in the United States, the amount of insurance varies from state to state.
When it comes to buying car insurance, home insurance, or life insurance, households typically decide for themselves how much insurance to purchase. It is not a decision made by the government. Unemployment insurance is different: it is provided by the government rather than by private companies. This insurance is funded by taxes levied on firms and workers together.
The reason unemployment insurance is provided by the government is because it might be difficult for private firms to provide this coverage. Private insurance companies rely on the fact that not everyone makes claims on insurance at the same time. For example, a provider of home insurance knows that 20 percent of the houses that they insure will not burn down in the same month. But in a recession, the high rate of unemployment means that a lot of people claim benefits at the same time. If private insurers were providing the benefits, insurance companies might go bankrupt, leaving workers without insurance. The government, by contrast, can use its ability to borrow, so it can finance unemployment insurance in one year from tax receipts it will receive in the future.
In the United States, the amount of insurance you receive typically depends on how much you have earned over the past year. A rule of thumb is that workers get about 25 percent of their wage income paid back through unemployment insurance. Benefits are available for only 26 weeks, although this is usually extended when the economy is in a recession. Other countries have much more generous programs. [***“The Ins and Outs of Long-Term Unemployment,” OECD Employment Outlook 2002, accessed June 30, 2011, http://www.oecd.org/dataoecd/36/48/17652683.pdf. Table 4.1 provides an extensive cross-country comparison.***] In Denmark, for example, unemployment benefits are about 90 percent of labor income and can last for up to 4 years.
Unemployment insurance has two main effects. First, and most obviously, this insurance makes it easier for unemployed people to sustain their level of consumption until they regain employment. Thus this form of insurance helps support consumption smoothing. Second, unemployment insurance affects the incentives of the unemployed. If individuals know they will receive some income even when they are unemployed, they are more likely to be willing to search extensively for good jobs. Instead of feeling the need to take the first job that comes along, people can wait longer and search longer for a job that is a really good match.
Unemployment insurance therefore contributes to labor market flexibility. It is, however, tricky to decide just how much unemployment insurance should be provided. After all, if unemployment insurance is too generous, then unemployed workers will be tempted to defer getting a new job for a long time—perhaps indefinitely. For this reason, governments usually restrict the period of time for which a worker can collect insurance to provide an incentive for them to search for a job.
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