Unemployment Policies in an Economy with Adverse Selection

This paper studies the effects of unemployment policies in a simple static general equilibrium model with adverse selection in the labor market. Firms offer a contract that induces the self-selection of workers. In equilibrium, all unskilled workers are screened out and some skilled workers are rationed out. It is shown that the provision of unemployment insurance (UI) raises involuntary unemployment by encouraging adverse selection, while unemployment assistance (UA) - or subsidy to unemployment - reduces involuntary unemployment. A simple efficiency wage model is also presented to show that either of the two policies reduces employment by taxing effort and subsidizing shirking. The key is whether the social role of unemployment is a sorting device or a worker discipline device