Uncertainty, Unemployment Insurance, Individual's Optimal Stopping Time and Duration of Unemployment

Abstract

Building on the tools developed for American call options in financial markets and the optimal timing of investment under uncertainty in economics, this paper proposes a stylized equilibrium model to study the optimal time for a risk-averse unemployed individual, who receives an unemployment insurance benefit and may receive a recall from the old job, to exit from a waiting (and hence unemployment) state and start a new job. It is shown that as a result of the individual’s exercising the optimal timing strategy, there is a duration of “waiting” and that this duration is affected by a number of economic factors, prominent among which are uncertainty on the part of the unemployed individual and the attitude of this individual toward risk.

Keywords: Unemployment insurance, income, utility function, Brownian motions, search, waiting, exit, continuation region

JEL Classification: D81, D84, E24