Question

2. Consider an economy of identical individuals who earn a wage w while working and nothing when they don't. With probability 0 < p < 1, the individuals become unemployed and earn nothing. When unemployed, individuals get an employment insurance (EI) benefit of b from the government. When working, individuals pay a tax of t ∗ w to ?nance the EI program. Assume that agents have no other source of consumption in either state. Let u(c) = ln(c) denote the individual's utility from consumption c in a given state.

(a) Explain the rational for assuming that dp/db > 0[1-2 sentences]. [1 mark]

(b) Use the formula for optimal EI benefits to explain why neither a benefit of zero nor perfect insurance (equal consumption in both states) is optimal. [2 marks]

Answer 1