Free Capitalist Network - Community Archive
Mises Community Archive
An online community for fans of Austrian economics and libertarianism, featuring forums, user blogs, and more.

Labor Economics #4 - Unemployment Insurance

Labor Economics #4 - Unemployment Insurance
by Alex Merced

These days unemployment insurance has become more of an issue than it has in recent times. The debate on this issue seems to be misguided. To really understand the unemployment insurance issue, or the issues regarding any kind of insurance you must understand what insurance really is.

Many government advocates always discuss the role of goverment in providing a safety net for those who can't afford to pay for one themselves, this is the purpose of insurance. An insurance company pools the resources of those who have more to write contracts to cover the costs of unforseen risks for premiums that are far less than the cost of not having the insurance contract. This creates a mechanism to handle risk that doesn't deplete resources in the economy since the premiums from unrealized risks pay off the costs of those contracts which are exercised. (although due to corporatist/monopolist partnerships between insurance companies, government power has dimished the accountability of Insurance and other industries to it's consumers. an issue for another time...)

This is why many Anarcho-Capitalist such as myself see a stateless world as one where many insurance companies and similar institutions arise and compete to fill the place of the social safety net in the absence of government, with arguably much better results. One of my favorite writings on the subject is Robert Murphys "Chaos Theory".

Unemployment insurance specifically can be a useful service to help make the transition between jobs for individuals much easier, and in the grander scheme of things ease the pain when resources shift from one industry to another as the wants and needs of people change. The issue becomes what is best way to provide such insurance to individuals, the government or via private enterprise?

The Forgotten Role of Insurance in Risk

In assessing this situation is what is lost is that insurance has much great role to play than just the benefits received when exercising a insurance contract. Insurace also serves as a mechanism to internalize many risks and costs, and incentivize prudent behavior.

 Let's use the example of car insurance. The premiums you may pay for your car insurance factor in many different variable; your driving record, your age, education, the model of the car, even the color to assess the risk of you getting into an accident or having your car stolen. If you buy a Red Ferrari, the chance somone may want to steal your car increases and so does your insurance premium which creates a financial incentive to choose safer car which will less likely be stolen. Also, if you were to get into an accident and file a claim the next time you purcahse insurance your premiums will be higher which again creates an incentive to be a safer driver. Overall, the premium mechanism is arguably vital to having a safety net like car insruance not cause moral hazard.

 Let's pretend the government provided quality car insurance free or at a uniform fee versus what you would've paid in the private markets. The incentive to not buy the ferrari or drive safely are now diminished, cause you either didn't pay or didn't have a differential in what you would pay depending on your behavioral choices.

So it's not only about the benefit, but cost to have the benefit that helps regulate the abuse of the benefit. So now let's apply this concept to unemployment insurance.

The Moral Hazard of Unemployment Insurance

Under the Government provided system of Unemployment the employer pays the costs of insurance, very similar to the situation in retirement and healthcare created out of ERISA. The Premium the employer pays is based on a percentage of the taxable salary of the employee (which is an incentive to give smaller salaries), and is not keyed into in any way other risks such as...

- Does the Employer run a sustainable company that is fiscally sound (if not, the risk is greater)
- Does the Employee have a stable work history (if not, the risk is greater)
- What is the background/education/skills of the Employer/Employee
- What is the Turnover Rate of the Employer (higher, the greater the risk)
- How difficult is it find a similar job

Since there things are not priced into the premium, the premium may be below market or above market depending on the employer and their employee. Since the employee doesn't pay the premiums directly, they have no incentive to take a sustainable job at a company that's well run, because the unsustainable company will probably pay higher salaries which makes it harder for good companies to compete with reckless companies in purchasing talent. The reckless company may go out of business a year later but the unemployment benefit as a percentage of the higher salary may outweight the smaller salary at the sustainable job which makes it hard for modest growth sustainable companies to compete.

This is similar to deposit insurance and the savings rate, the more reckless banks will generally have a higher savings rate but since depositors don't pay their deposit insurance directly they will deposit their money in the higher savings rate bank which more than likely has some liquidity problem causing a whirldpool of good resources into bad places.

All this doesn't take into consideration the political ramifications of having government run unemployment insurance, as we see now with congress using unemployment as a fierce political issue to buy votes by extending the benefits well beyond what has been payed into them and was promised.

The Virtue of a Private Unemployment Insurance

If people could and would purchase their own private unemployment insurance, or employers voluntarily provided it from priavate insurance companies all the factors that weren't calculated into the premium now would. The insurance company would investigate the employer and the employee to assess the risk they both present in the risk of the employee becoming unemployed. So more risk, would equal high premiums leading to a lot of good incentives such as...

- An employer running a sustainably well run company who can't afford lavish salaries will be more competetive. The higher salary at the reckless company would also carry higher premiums, internalizing the risk of which is the more sustainable job. This would also be an incentive to be sustainable, cause it'll be hard to attract talent if working for the company generates high insurance premiums.

- The company would be incetivized to have a pleasent and safe work environment, cause not having one would increase their turnover rate which would increase unemployment premiums.

- The employee would have an incentive to be more prudent in choosing jobs, and to pursure more education and skills. Having a stable work history and lots of credentials and skills will only help them lower their unemployment premiums.

- If working in a niche industry that may take a year or two to find a similar job, the employee can choose to buy benefits beyond what's currently mandated (6 1/2 months) this allows the freedom for those who need more to get more and those who need less to get less.

The Bottom Line

Unemployment Insurance like insurance against any unforseen risk is a healthy institution to have, but the role these institution play in the economy is far greater than just providing benefits but also pricing in the risks of every actor into premiums internalizing many otherwise external costs. When government gets involved in the insurance business it often distorts this mechanism causing the externalities of these risks to remain external causing moral hazard and an economic drain from the increased claims from this moral hazard.

Posted Aug 15 2010, 08:45 PM by Alex Merced