An endogenous skill loss model of long-term unemployment

This paper considers a model in which the unemployed have to incur a cost to maintain their skills. If whether they have done so is not observable, the economy has multiple equilibrium supported by self-fulfilling beliefs on the part of the employers. There is a unique steady state equilibrium associated with each of these. In the first equilibrium associated with each of these. In the first equilibrium, which we call the Skill Loss Equilibrium, the long-term unemployed do not incur the cost and lose their skills; there is duration dependence and the exit probability of the long-term unemployed is lower. It is shown that in this equilibrium unemployment and long-term unemployment are higher, and, welfare and profits are lower than the No Skill Loss Equilibrium. The inefficiency of this equilibrium is characterised as externalities and constructive government action in form of positive discrimination and labour market policies are suggested.