Public Policy in a 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 equilibria supported by self-fulfilling beliefs on the part of the employers. One of these equilibria, which we argue is more likely to arise, has equilibrium discrimination against the long-term unemployed, who in response decide to let their skills atrophy. As a result, in this equilibrium the exit probabilities from unemployment are duration-dependent. It is shown that equilibrium discrimination survives even if workers are allowed to accept negative wages at the beginning of the employment relation. Since this equilibrium is highly inefficient, constructive government action in the form of positive discrimination, subsidies and labour market policies are suggested to correct the market failures. However, subsidies and positive discrimination by private firms are shown not to have beneficial effects. Labour market policies in the form of retraining of the long-term unemployed are beneficial but reduce the likelihood of a switch to the Pareto-preferred equilibrium. The most useful policy appears to be a limited form of positive discrimination by a government sector.