he unemployment problem in Europe, and especially the large proportion of people out of work for longer than six months, gives rise to the question of how effective an unemployment benefit system is for the labourforce. In Discussion Paper No. 1532, Melvyn Coles discusses an equilibrium labour market in which an unemployment benefit system cannot raise the average value of being unemployed in the long run. The author uses a standard labour-turnover framework, but distinguishes it by the asumption that entrepreneurs are not completely informed on all profit-making opportunities, with the result that the creation of vacancies takes time. The existence of a positive stock of unemployed, however, makes the filling of a vacancy relatively easy. The creation of a new job is affected by the current market wage, such that a high wage reduces potential profits and, hence, the rate of new job creation. As wages are assumed to be determined competitively, for a given number of jobs created, wages will vary inversely with the level of unemployment. If a government attempts to make the unemployed better off by increasing compensation, this increases their reservation wage. Employment becomes less attractive and, hence, unemployment remains high, but this time at a higher cost. Although a benefits system provides a partial insurance against business-cycle risk, it does so at big efficiency costs. The author argues that a similar insurance mechanism could be achieved through varying payments over the cycle – paying relatively high benefit rates in periods of high unemployment (recessions) and low benefits at other times (booms). Targeting unemployment compensation to recessions, when being unemployed is particularly costly, and reducing the value of remaining unemployed in booms would encourage greater downward wage flexibility. This, in turn, would substantially reduce average unemployment levels and lead to greater investment.

Designing a Cheaper and More Effective Unemployment Benefit System
Melvyn G Coles