Unemployed But Optimistic: Optimal Insurance Design with Biased Beliefs

54 Pages Posted: 2 Nov 2008 Last revised: 17 Nov 2008

See all articles by Johannes Spinnewijn

Johannes Spinnewijn

London School of Economics & Political Science (LSE)

Date Written: October 29, 2008

Abstract

Biased perceptions of risks change the perceived value of insurance and the perceived returns to avoiding these risks. I show empirically that unemployed workers overestimate how quickly they will find work, but underestimate the return to their search efforts. I analyze the consequences for the optimal design of unemployment insurance. With biased beliefs, contracts equalizing the marginal smoothing benefit and the moral hazard cost of insurance are suboptimal. Social and private insurance diverge; a paternalistic social planner corrects the moral hazard cost for the distortion in the insured's effort choice, while private insurers focus on the perceived rather than the true smoothing benefits. When unemployed workers are optimistic, privatizing unemployment insurance may result in inefficiently low or rapidly decreasing unemployment benefits.

Keywords: Moral Hazard, Biased Beliefs, Unemployment, Optimal Insurance

JEL Classification: D81, D84, D60, G22

Suggested Citation

Spinnewijn, Johannes, Unemployed But Optimistic: Optimal Insurance Design with Biased Beliefs (October 29, 2008). Available at SSRN: https://ssrn.com/abstract=1291566 or http://dx.doi.org/10.2139/ssrn.1291566

Johannes Spinnewijn (Contact Author)

London School of Economics & Political Science (LSE) ( email )

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00 44 (0) 20 7955 7022 (Phone)

HOME PAGE: http://econ.lse.ac.uk/staff/spinnewijn_johannes/

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