Wednesday, November 30, 2011

How much does race contribute to poverty in South Africa?

It is no one's surprise that blacks in South Africa are poor, less educated and less healthy than whites, given the still rather recent struggles through apartheid. But the country has also gone through a remarkable reversal of fortunes, with blacks now running the country and leading some formidable efforts to raise the blacks from chronic poverty. In some ways, these efforts are much more substantial than those that have been made in the US, where blacks are still a minority and yet have remained in poverty with little progress for decades. It is therefore of interest to understand how things have improved in South Africa, and whether the damage from apartheid has been overcome.

Carlos Gradín focuses on poverty and deprivation, both of which still show considerable gaps between blacks and whites, and comes to the conclusion that they are mostly explained by education and "family background" (parents' occupation and education). This all points to the fact that education is the big policy option, but it will take considerable time to reduce the gap.

These results are obtained by estimating a reduced-form equation for blacks and then letting them assume the characteristics of whites. Unfortunately, this procedure does not allow to determine whether there is still some discrimination against blacks, which would have been of particular interest in this context.

Tuesday, November 29, 2011

Are payroll tax cuts efficient?

While there is ample debate in various countries whether payroll taxes should be reduced or increased, there is little agreement. One side focuses on government revenue generation while the other is worried about the impact of such changes on economic activity. It looks like agreement is unlikely, as this is about different objectives. But maybe there could be.

Ossi Korkeamäki looks at a natural experiment in Finland, where the payroll tax was reduced by 3-6 percentage points in some provinces. As it is levied at the firm level, he studies the impact on firm activity, and finds nothing of statistical significance. If you are willing to look beyond statistical hairsplitting, most of the tax reduction went into profits, a little into wage and nothing into employment. But this is only looking at the firm level, there may be some aggregate effects, like those profits are getting consumed, right? Well, given that those receiving those profits are either pension funds or rich people, which both have lower marginal propensities to consume than the typical wage earner, that is not going to help economic activity either. So, in the end, it just looks like the government lost some revenue in this experiment, and the likely decrease in government purchases cancelled out any small output effect there may have been.

Monday, November 28, 2011

Corruption and the exchange rate regime

A fixed exchange rate regime is a sign of an authoritarian and weaselly government nowadays. Letting your currency float lets markets freely show when policies are weak. Governments who are afraid of showing such weakness either get a fixed exchange rate regime or announce a floating one and in practice manage it to make it look stable as a fixed one. This is the so-called fear of floating, common among corrupt governments. This would indicate that the choice of the exchange rate regime could be determined by the political regime. Could the causality run the other way?

Katherina Popkova studies this question and finds the rather striking result that it makes sense to have an fixed exchange rate when you are corrupt and corruption has a strongly positive impact on output. The logic is that in such circumstances taxation is not that much distorting, thus seigniorage can be efficiently replaced by taxes. That said, some may argue that it is a silly idea to mention that corruption may have a positive impact on output. Yet, it is far from empirically settled whether corruption has a positive or negative impact.

Friday, November 25, 2011

When random taxation is better

As many governments are scrambled for new revenue, tax evaders are falling under more intense scrutiny than usual. Southern European countries are particularly well known to be a paradise for tax evasion, as authorities are rather week and corruptible. As enforcement is rather difficult to improve, could an institutional change work better?

Stéphane Gauthier and Guy Laroque think they have found a solution, which is to randomize taxes. This builds on the fact the risk tolerance varies across tax payers and that the latter can face stiff penalties (or inconvenience) when caught evading. Suppose the skilled worker is more risk averse than the unskilled one, and you want to redistribute from skilled to unskilled, but cannot observe skills (or risk aversion). The skilled will try to pretend to be unskilled to avoid taxation. But if taxes are random, then he has fewer incentives to do so. If risk aversion goes the other way, then of course, tax evasion becomes worse. The authors offers no evidence on the correlation of risk aversion and skills or income, thus it is hard to tell how useful this scheme would be, and how welfare would be improved.

NB: The authors could have just spent a couple of seconds at the paper before submitting it. The forgot to BibTeX it, and none of the references show up. This is unfortunately a carelessness that I have encountered too often with French economists.

Thursday, November 24, 2011

How to get fair elections in new democracies

There are several opportunities for new democracies in the Middle East, and if it is done well, democracies could actually establish themselves for good. This can only happen if politicians respect electoral results and the voters can trust the results as well. How do you get this to work?

Takeshi Kawanaka and Yuki Asaba offer some suggestion looking at electoral administration systems. But how do you get an independent and competent electoral commission? This is not just a matter of resources, the incentives for politicians need to be right. The critical layer is the party in power, which can change statutes, allocate funds and appoint commission members. Having a fraudulent electoral commission makes it easy to get reelected, but it can become costly if election results are challenged in the street. Rather, the ruler may want to have a credibly independent and competent electoral commission, as a win would then remain unchallenged. The ruler may also be motivated by avoiding costly bribes.

One aspect the paper ignores is that politicians are careers driven. A politician that turned out to be competent and honest in local government may have a shot at higher office. This is why he should not be corrupt, and the electorate will only promote the non-corrupt ones. Thus, to build a democracy you ned to work from the bottom up, so that proven incorruptibles end up ruling the country. Sadly, American nation building does the exact opposite, and it fails, the latest example being Iraq. By choosing to first hold national elections, the corrupt politicians got a free pass to power, and they have not looked bad since.

Wednesday, November 23, 2011

How societies can collapse

Some say that the western economies are doomed and that China is taking over as the main economic power. I do not think we are quite there yet, after all China is still not the largest economy, and by far, despite its huge population. And China may itself be at risk of a financial crisis due to its very inefficient banking system. At least it could diffuse an impeding real estate bubble, but this is not the topic of this post. The worst case scenario, however unlikely it may be, is the western society would collapse. It has happened before, so it would be interesting to learn how this could happen.

Rodrigo Pacheco, Newton Paulo Bueno, Ednando Vieira and Raissa Bragança study the collapse of the Mayan civilization, which was well organized, covered a lot of territory and had a long history. Yet it appeared to collapse within a few years in the 9th century. How could this unravel to quickly?

Their point of departure is that societies are inherently resilient. They can be subject to shocks, even large shocks, and they bounce back. Yet, sometimes they do not. What makes this happen? The main point is that dynamics are important. It is believed that a severe drought was the trigger. But this civilization had such drought before and survived. The last one was different because it brought about systemic changes. There precise nature is difficult to determine, after all we do not know that much about Mayan history. One hypothesis is that the drought brought some unrest which made it worse. For example, agriculture used terraces, which are costly to maintain and rely on the good shape of the ones uphill. Under a severe drought, maintenance may have been lacking, and after some time the terracing system fell apart, and with it probably the structure of society. In short, there needs to be the dynamics of a death spiral for a collapse to happen, but it will still take some time.

Tuesday, November 22, 2011

European credit ratings: a case of self-fulfilling expectations

Europe is a mess, and one has to wonder why. First, there is no reason that the credit difficulties of Greece should have any consequences on the Euro. I doubt the US Federal Reserve would feel compelled to do anything if a state were to default on its debt, and nobody would claim it should. Why should it be different in Europe? Because politics want it.

To make things worse, the credit rating agencies generate self-fulfilling expectations. These are of a different kind of those that make that Greece will have to default. Witness yesterday's announcement by Moody's while threatening a downgrade of French debt: "Elevated borrowing costs persisting for an extended period would amplify the fiscal challenges the French government faces amid a deteriorating growth outlook, with negative credit implications." In other words, high credit costs would lead to a downgrade and this would lead to even higher credit costs, etc. The rating is not about the intrinsic risk of default (what rating agencies are supposed to measure) but about the expectation of where the rating should, as signaled by the cost of credit. And this after Standard and Poor's downgraded the same debt "by error." The rating agencies are clearly not helping at this point.

Monday, November 21, 2011

Meta-analyzing the price puzzle

Meta-analysis is the analysis of the literature on, say, the estimate of a particular elasticity. This is common in medical studies, where each individual study has usually little statistical significance, but aggregating them may give the results more power. In Economics, there are few meta-analyses (although there is a society on the topic) as study samples are statistically much more sound and each study takes so much time that there is little incentive to do a lot o the same topic. Yet, this happens for some themes.

One such theme is the price puzzle: many vector-autoregression models show that a monetary contraction is immediately followed by a rise in the price level, which is rather counter-intuitive. Marek Rusnák, Tomáš Havránek and Roman Horváth found 70 articles from 31 countries providing 210 estimates of the response at five horizons. Can one then simply do a statistical analysis on these estimates? That is not so easy, as there may be a publication bias. As the puzzle is now well documented, journal editors are not particularly interested in studies that demonstrate it again. The authors claim that there is such a bias, but I have to confess I do not understand how they come to that conclusion.

The price puzzle is on average present, and prices eventually decrease as suggested but all theories. But there is substantial variance in the results, which the authors show can be explained by what variables are included or what variant of a vector-autoregression is run. This unfortunately confirms my frustration with this field: there is a dizzying array of methods and specifications that yield different results, and it is impossible to tell which one is right. Maybe we need a bit more theory to discipline this.

Friday, November 18, 2011

When should a child start school?

How early should one send a child to school. Too early, and she may miss critical time with parents and not be ready for school. Too late, she may have to deal with classmates that are not as fast or as developed (see previous post on redshirting). But it is not just a question for an individual, one needs also to figure when as a society school should start. France, for example, offers public kindergarten very early (2.5 to 3 years old), and it much more pedagogical than daycare. Most French kids enter first grade with reading skills. In the US, kindergarten is at age of sex or even seven, and there is little teaching. China is similar.

Dionissi Aliprantis uses the Early Childhood Longitudinal Study and exploits cross-state and cross-time differences in the cut-off date that makes children eligible for kindergarten as five-year olds. Children were analyzed in kindergarten, 3rd, 5th and 8th grade. It turns out that an earlier cut-off date is better, and an earlier birthday as well, as long as the child remains eligible. But the analysis only pertains to rather small start age differences, so it is difficult to extrapolate to even earlier start date as seen elsewhere.

Thursday, November 17, 2011

The excessive taxation of married couples in Italy

In these times of fiscal austerity, governments are scrambling to find tax revenues and in particular to close loopholes and to chase tax evaders. While the goal is to raise more revenue (and be somewhat fairer, as tax evaders tend to have higher incomes), that can have the adverse effect of actually reducing tax revenue. While it is clear that the Laffer Curve is correct, there is little evidence that in aggregate any western economy is on the right side of its peak. But there there are some individual circumstances where it is.

Fabrizio Colonna and Stefania Marcassa discuss the taxation of married couples in Italy. Taxation in Italy is based on the individual, with deductions for children and the non-working spouse. As the incidence of these tax credits on the marginal tax credit decreases with the income of the first earner in a couple, typically the husband, there is a strong incentive for wifes of lower income husbands to work, full-time or part-time. This reduces the labor supply of the poor, increases poverty and increases the strain on welfare programs.

The paper estimates a complex labor choice model and runs two scenarios: the current one, and one where households can choose to file taxes individually or jointly. The latter boost women's labor force participation rate by 3 percentage points and reduces the proportion of women under some poverty threshold by half that. Others scenarios, such as gender-based taxation, are explored as well. In all scenarios, the assumption is that taxes are revenue-neutral. As poverty is reduced, the need for redistribution is reduced, something that makes the scenarios even more attractive.

Wednesday, November 16, 2011

Growth by saturation

When you compare rich and poor economies, you notice that many things differ between them One of them is that rich countries enjoy a much larger diversity of goods. It is not just that they carry more broads categories of goods, there are also more variations of a given good. For example, rich countries may have more car types and each model is sold with many more variations than in poor countries. Explaining this could be interesting.

This may be the motivation of Kozo Kunimune who builds a growth model with three essentially characteristics: there is constant growth in factor productivity, there is a ranking of goods with respect to the utility they provide, and consumers have a saturation point for each good. This implies that once they are saturated with a good, any "excess" production capacity can be dedicated to another good. As there is a strict ordering, goods are satisfied in succession and the number of goods defines the level of development. Also, the time needed to satisfy a new good decreases if the growth rate is constant, a feature that sounds empirically correct. But of course, there is no evidence whatsoever that we have such "lexicographic cum Leontieff" preferences. The model also violates elementary principles of Economics, such as local non-satiation. Not a particularly useful model.

Tuesday, November 15, 2011

Non-conformism in academia

In economics, there is the mainstream and various heterodox fractions that do not identify with the mainstream or each other. Too many, the heterodox seem like annoying and useless chatter. But they fulfill an important role, which is to keep those in the mainstream on their toes. This is part of the scientific process: challenge long and widely held views to check whether they are still valid. And even if the challenge is wrong, it makes those in the mainstream think about the axioms the build their theories on.

Vela Velupillai makes the case that dissenters are typically silenced by the mainstream, but may prevail in the long-run, citing many examples of mathematical economics, in particular the work of Pietro Sraffa. And this is really what tenure is good for: a dissenter will have much trouble publishing but may ultimately still contribute a lot to scientific advances.

We are in times were dissenters seems to have a more receptive audience. Indeed, the current crisis is seen by some as a failure of Economics, thus it is easy to criticize it. But it also highlights that dissenting can be very distracting if it is poorly focused, uniformed and populist. In this regard the recent dissenting by Colander, Krugman and Stiglitz has, I think been counterproductive, as I have occasionally discussed here. It is good to criticize the fundamental assumptions of the mainstream. It is better, but not necessary to offer alternatives. But it is counterproductive to dissent on the basis of a old read of the literature, and a literature that has in the meanwhile evolved to address these supposedly new criticisms.

Heterodox Economics has thus gained a fresh wind, simply because it is different from the mainstream. But what does it have to offer? Peter Skott, a heterodox economist himself, argues that it is still far from being an viable alternative. While heterodox approaches usually reject microeconomic foundations in macroeconomics, they should not throw out the baby with the bath water, i.e., ignore microeconomics altogether. And while the heterodox analysis for income distribution has focused on the labor income share, the large changes in income inequality happened within labor income. Finally, the heterodox literature is just as guilty of ignoring many of the suddenly relevant intricacies of the world of finance.

There is still a lot of work to do, and instead of pursuing an excess of mutual accusations and claiming Economics is useless, it seems much more appropriate to put more resources into making it better, heterodox or mainstream. After all, medical research was not defunded when the HIV/AIDS epidemic made ravages.

Monday, November 14, 2011

About beer

Beer has been an important part of human well-being, and this for thousands of years. While the economic literature has dealt rather little with it, many great papers have significantly evolved at the pub. Still, I have previously reported on a conference on the Economics of beer, and open source beer.

Now, let us talk about the economic history of beer, thanks to Eline Poelmans and Johan Swinnen. Brewing in the middle ages was he realm of monasteries, with rather small output and a lot of product diversity. With technological advances and reduction in transportation costs, commercial breweries took over and especially over the last hundred years they lead a remarkable trend towards consolidation. After all those mergers and acquisitions, product diversity was considerably reduced. This is all changing now, and tastes have become more sophisticated and local micro-breweries are on the upswing. In some ways, beer has become more like wine.

Sunday, November 13, 2011

Why are school counselors so bad?

Recent news articles following up on the Occupy X movement have focused on youth unemployment and student debt. One aspect of this that strikes me are the absurdly bad choices students make. And from discussions with undergraduate students I ahad over the years, school counselors shares share part of the blame.

For one, they keep sending students into supposedly easy majors, even if job prospects are slim. If a student cannot handle the rigors of a serious university education, he should not be in university. He is less likely to get grants, more likely to take longer to graduate and then be in debt, less likely to get well-paying jobs there after and thus will face students debts for many years. Also, students with ambitions in better majors are told to switch to easier majors when they face difficulties, instead of helping them to overcome these difficulties. This is in particular the case for ethnic minorities and women, and one then wonders why they are underrepresented in science and technology. The problem is that counselors perpetuate or even amplify prejudices. An example is Neil deGrasse Tyson who was told that as a black he should go to basketball, not physics, and was not offered the help white students were getting when he struggled with classes, when blacks are not expected to excel in physics.

Also, counselors seem to obsessed with finding the "right college," which often an obscure little university where every major has only two or three faculty, and turn out to be expensive. The usual explanation is that the students needs small classes. This seems like another case of someone who is going to be highly in debt for a long time. And to come to Economics, the major is filled with undergraduates who did not get in or got kicked out of the business school, most often for failing on business mathematics and statistics. And what do counselors tell them? Get into a similar major, like Economics (or Psychology), ignoring that those quantitative skills are even more needed.

Why do counselors give such bad advice? I do not have an answer beyond wild guesses. But my casual observation tells me that the best psychologists or education professionals do not espouse this career, and for a good reason: on average the entry salary for a graduate of a Masters program in school counseling is an astounding US$33,000. In some sense, this is the bottom of the barrel that is trying to give advice to people on how to avoid falling to the bottom of the barrel. That is hardly inspiring. Schools should hire at least a few people who had successful careers to show how it is done, for example retirees.

Friday, November 11, 2011

Miss sharing with future generations? You are not missing much

Markets are not complete. Two major ways in whuch they are not complete is that we have borrowing constraints and that we cannot exchange with future generations. The latter can be a big deal when we think about the valuation of future amenities (like the environment) or long term risks. In particular, future generations could make us behave in certain ways if they could influence some of today's markets. This is precisely why the overlapping generation literature emerged, and a principal conclusion of it is that the government needs to intervene, in particular by providing an security that lives beyond generations: the government bond. While there is obviously a welfare cost to the lack of future generations on current markets, how large is it? The literature tells us the welfare benefit of the government bond is large.

Roel Mehlkopf just defended a dissertation on this topic, focusing on risk. In a nutshell, the cost is not that large, and it all has to do with distortions on the labor market. For one, those you ex-post need to transfer to another generation face a commitment problem in the sense that they want to reduce their labor supply, for example by retiring early. Once you take this into account, there is little to redistribute, and it can even be welfare-decreasing to transfer. This rationalizes why pension funds needs to be solvent at all times, even if they are solvent in the long run. One important implication is that when cuts are necessary in pensions, they should be larger for the young workers, as this reduces the labor market distortions.

Also, the dissertation points out that comparing to a situation with fictitious markets between non-overlapping generations can be misleading. Indeed, this implies that they all have the same weight in a social welfare sense. But there can be good reason for a social planner to deviate from this, and the analysis above, fr example, implies that future generations benefit more from risk sharing than current ones (who are at least partially locked in by past decisions). This should entice the social planner to give more weight to current generations, even beyond normal discounting of the future. And as only current generations for for the current government, we are not far from that optimum.

Thursday, November 10, 2011

Physiology and Malthus

The Malthus model of economic growth (or the lack thereof) is now standard fare in undergraduate education. Basically, it shows that there is a limit to the size of an economy that hinges on decreasing returns to labor in production and on mortality increasing as standards of living, as measured by GDP per capita, decrease. Those two critical assumptions are based on observations that were certainly valid at Malthus' times, and are likely to still be true today.

Carl-Johan Dalgaard and Holger Strulik go a little bit further in this theory. As more food is available, people grow taller. But being tall requires more food to sustain the body, which provides an additional reason for stagnation. This makes it more difficult to break loose from this "development trap" and may explain why economies stagnated for so long. But as Malthusian theory, this dies not explain why the economy suddenly exploded in the 19th century.

Wednesday, November 9, 2011

Acquiring a firm for its workforce

Why do firms get merged or acquired? In the end, the hope is that it increases firm value, although the stock market response is often negative. It may also be for (anti-)competitive reasons, as firm try to buy the challengers. Or it may be to acquire a patent portfolio, technology, or access to a client list or new markets. I may forget some other good reasons.

Paige Ouimet and Rebecca Zarutskie show that mergers and acquisitions can also be the result of a drive to get access to the other firm's pool of workers. This is particularly true when the labor market is tight and the workers carry high human capital. Interestingly, wage tend to increase and turnover tends to decrease after such mergers. Thus not all employees should be afraid of M&As.

Tuesday, November 8, 2011

Why is funeral insurance so popular in Africa?

Probably the oldest form of insurance is existence is funeral insurance, which takes cares of burial (and now cremation) costs at death. In developed economies, its popularity has vanished, while it is still very common in Africa. One reason could be that when life insurance is available, people believe it is sufficient to cover funeral costs, and the beneficiaries are committed to take care of this. When life insurance is not available or when not commitment can be elicited from descendants, then funeral insurance ensure your body is properly disposed of.

Erlend Berg writes a model along those lines and finds that only middle income should favor funeral insurance. The rich do not face a tight budget constraint and the poor cannot afford it. Then using a marketing survey conducted in South Africa finds results that are consistent with the model. This lack of commitment in Africa for financial matters is pervasive. It is, for example, at the heart of the strange institution that ROSCAs are.

Monday, November 7, 2011

Why top MBA programs do not disclose grades

I have always been puzzled by the policy of many top MBA programs not to disclose the grades of their students. Even more puzzling is that they by and large manage to enforce this policy even from their top students, who should obviously want to signal that they are at the top of their class.

Daniel Gottlieb and Kent Smetters wondered about this as well. Such policies are voted by the students (who in the US own the grades) on the argument that it allows them to take more difficult classes without adverse consequences. Yet the evidence is that they learn less when such a policy is in place, which explains the general opposition to it from faculty. So, one can conclude that students are lazy (nothing new here), but is such a policy limited to top MBA programs? Why not in lesser programs, or other professional schools?

Gottlieb and Smetters point out that students have two signals for potential employers: their grades and the selectivity of the program. They are also risk averse, and at the start of their studies do not know how well they will do. In top schools, the selectivity signal is very strong and the students rely on it, while the "average" grade is superior in expected terms. In lesser schools, the selectivity signal is much weaker, and hence students try to distinguish themselves on the labor market in other ways, for example with grades.

To some extend, the same is happening on the Economics PhD market. When you look at the recommendation letters form the top schools, all candidates are the best in a generation in their field (I am exaggerating on a little). Thus the letter looses a lot of its value, and all that remains is the entrance selectivity of the PhD program. Lower ranked programs are much keener to differentiate their students and push the particularly good ones.

Friday, November 4, 2011

Adaptive versus rational expectations

There was a time where macroeconomics was ruled by adaptive (or backward-looking) expectations, like the much-ridiculed chartists. Then there was a revolution and rational (typically forward-looking) expectations were widely adopted, realizing that people are not stupid and will try to use the available information, including what other agents may do, to figure out what the future holds. Rationality, and in particular rational expectations, has recently come under attack because models failed to predict recent bubbles and crashes. I think this is mistaken, as detailed on several occasions on this blog.

Gregory Chow, however, longs for a return to adaptive expectations for three other reasons. The first is that it is empirically more plausible. Exhibit A is a regression of the stock prices of 50 blue chips in Taiwan on current dividends and past dividend growth. Despite a lowly R2 of 0.111, the fact that the coefficient on dividend growth is positive and significant is taken as evidence of adaptive expectations. I do not find this convincing, as a similar result could emerge with rational expectations if the dividend growth process is persistent.

The second reason is that "there is no reason to believe that the expected values [computed from an econometric model of the rational expectations] will have a sum, after discounting, which equals the actual current price." I think the underlying reasoning is that a statistician can only use a linear combination of past observations, thus economic agents will, too, and this all looks like adaptive expectations. But economic agents, and nowadays statisticians, are more sophisticated than that, and a gigantic literature in finance has shown that, for example, non-linearities and endogenous volatility, too name a few, are important. Even though statisticians have become much more sophisticated, they are still running behind economic agents and are far removed from being linearly backward-looking.

The third reason is that macroeconomists started using rational expectations simply because it was required to deal with the Lucas Critique, empirical evidence be damned. While I can be sympathetic to the argument that rational expectations was adopted without much direct empirical evidence, I also believe that economic agents do try and avoid systematic mistakes and that their expectations contain at least some rationality. And as much literature has shown, a modicum of rationality can bring markets darn close to prices that look like perfectly rational ones.

Thursday, November 3, 2011

Is index-based weather insurance useful?

Whenever you are facing a risk, you want to be able to hedge against it (at least if you are risk averse). For this, there are all sorts of insurance policies. There are also markets in all sorts of instruments that allow you to find the right contingent claim for your situation. This includes farmers (and others) who want to hedge against meteorological risks. If you crop yields depend on weather patterns, you are looking for securities that pay out depending on some weather statistic. And they are available and have been heavily pushed by aid agencies in developing countries.

Chiratan Banerjee and Ernst Berg say they may not be such a great idea. They take the examples of rice farmers in the Philippines who bought wind-speed based indexes on the hypothesis that rice yields are lower when there are typhoons. But rice is remarkably resistant to typhoons and wind in general, the reason why it is so popular in the region in the first place. This means that rice farmers are heavily over-insured. That is especially bad and farmers are now confused about the concept of insurance as it looks like they face more risk than before.

Tuesday, November 1, 2011

Unemployment insurance in developing economies?

There is no doubt that absent moral hazard, insuring against unemployment shocks is welfare improving. But moral hazard, either through the unemployed not searching hard enough or rejecting job offers, can have a vicious effect on welfare if it is sufficiently widespread and successful. In addition, as unemployment insurance contributions typically do not depend on unemployment risk, only bad risks want to participate, and the insurance collapses without mandatory participation. With all this in mind, does it make sense to implement unemployment insurance in developing economies, where there is a large informal sector that makes mandatory contributions difficult to enforce and where moral hazard is, of course, rampant?

David Bardley and Fernando Jaramillo show that introducing unemployment insurance actually makes the formal sector more attractive and that we should thus not worry that much about the current level of informality. The presented model, however, does not allow for someone to collect UI benefits while working in the informal sector, a very real possibility that could easily overturn the results.