On the Provision of Unemployment Insurance when Workers are Ex-Ante Heterogeneous

Labor market outcomes demonstrate considerable variation between and within skill groups. We construct a general equilibrium model with incomplete markets and exogenous differences that matches these facts. We study the role of exogenous heterogeneity in choosing the optimal re- placement rate and the maximum benefit for an unemployment insurance (UI) system. The optimal average replacement rate is 54%, compared to 10% in a model without the features of exogenous heterogeneity. The relatively generous choice in our model is due to the redistributive role of UI – a manifestation of two elements. First, workers who are unemployed more often receive positive net transfers from the UI system because they draw resources more frequently. Second, the existence of a cap makes UI benefits progressive. Our main result holds even in the presence of a generous progressive taxation system.