Paul Frijters & Michael Shields, School of Economics Discussion Paper No. 447 September 2010, School of Economics, The University of Queensland. Australia.


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In this paper we contribute to the recent literature that has investigated the potential economic advantages of unemployment benefits, by developing a model where young individuals in education have to irreversibly choose a degree of specialisation positively related to future unemployment risk, market wages for different types of specialisation have to compensate risk-averse individuals for these risks. Unemployment benefits affect the incentives for specialisation and thereby the long-run composition of the workforce, the wage structure, and output. I address this issue in OLG search models with risk-aversion, talent heterogeneity, endogenous specialisation distributions, and competitive wage formation. The main results are that 1) higher unemployment benefits are related to higher mean specialisation and at low levels raise efficiency and welfare; 2) even though wages compensate for risks, unemployment risk and individual wages are generically negatively related when there is talent heterogeneity; 3) the composition of the workforce changes slowly with changing incentives, leading to long lags between welfare system changes and average outcomes (unemployment and output) and lead to longer lasting effects of shocks in regions with higher unemployment benefits.