Unemployment Insurance In An Economy With A Hidden Labor Market

This paper considers the problem of optimal unemployment insurance in a moral hazard framework. Unlike existing literature, unemployed workers can secretly participate in a hidden labor market; as a consequence, an endogenous lower bound for promised utility preventing "Immiserization" arises. Moreover, the presence of a hidden labor market makes possible an extra deviation and therefore hardens the provision of incentives. Under linear cost of effort, the authors show that the optimal contract prescribes no participation in the hidden labor market and a decreasing sequence of unemployment payments until the lower bound for promised utility is reached. At that moment, participation jumps and unemployment payments drop down to zero. For the case of non-linear effort cost they calibrate the model to Spain.