OPTIMAL UNEMPLOYMENT INSURANCE IN

CONTINUOUS TIME.
LEANDRO GORNO

1. Introduction.
In this short note, we develop a continuous time version of the model
of unemployment insurance of Hopenhayn and Nicolini (1997). We
start with a basic model in which effort and taxes are exogenously
fixed. We show that in such model, optimal benefits follow a simple
Euler equation. Then, we sequentially endogenize two key ingredients.
First, we investigate the optimal choice of verifiable effort. Second, we
study the case in which effort cannot be verified, thus leading to the
introduction of incentive compatibility constraints.
2. Exogenous effort.
In this section, we develop the basic model in which effort and taxes
are exogenous and benefits cannot be stored privately. Throughout
this note, we consider a subjective discount rate > 0 for the worker
which may differ from the interest rate r > 0 used by the government
to evaluate intertemporal cash flows. Flow utility of consumption and
the arrival rate for job opportunities are respectively given by function
u, : [0, +) R, which are twice continuously differentiable, increasing, strictly concave and satisfy u0 (0+ ) = 0 (0+ ) = +. Consider
a fixed effort level a 0, a total tax T and fixed employment value
J > 0. Let (a). The unemployed worker value V J solves:
V = u(b) a + (J V ) + V .
Date: November 4, 2014.
Getulio Vargas Foundation (FGV/EPGE Escola Brasilera de Economia e Financas),
Praia de Botafogo 190 (andar 11), Rio de Janeiro, RJ, Brasil 22250-900.
Email: leandro.gorno@fgv.br.
1

OPTIMAL UNEMPLOYMENT INSURANCE IN CONTINUOUS TIME.

Now consider the problem of the government agency providing the

benefits. Her profit function P (V ) solves
n
o
0

rP (V ) = sup b + (T P (V )) + P (V )V ,
b0

where
V = V u(b) + a (J V ).
The FOCs are:
1 P 0 (V )u0 (b) = 0
Note that this equation already implies that P 0 (V ) < 0. Using the
envelope theorem on the HJB equation for P , we get
P 00 (V )V = (r )P 0 (V ).
From now on, let b b (V ) denote optimal benefits. Differentiating
the FOCs w.r.t. time we get
P 00 (V )V u0 (b ) + P 0 (V )u00 (b )b = 0.
Replacing the expression for P 00 (V )V found through the envelope theorem, we get the following Euler equation:
u0 (b )
b = 00 (r )
u (b )
Note that

u0 (b )
>0
u00 (b )
This means that r > implies b > 0, while r < implies b < 0.
Finally, in the case of equal discount rate, we get b = 0 and optimal
benefits are constant over time. We can pin down their level using

b (V ) = u1 (V + a (J V )).
Profits are given by
P (V ) =

T b (V )
.
r+

OPTIMAL UNEMPLOYMENT INSURANCE IN CONTINUOUS TIME.

3. Verifiable effort.
In this section, we allow the government agency to choose the optimal
level of effort. Given an effort a a(V ) and benefit schedule b b(V ),
the unemployed worker value V solves:
V = u(b) a + (a)(J V ) + V .
Now consider the problem of the government agency providing the
benefits. Her profit function P (V ) solves
n
o
0

rP (V ) = sup b + (a)(T P (V )) + P (V )V ,
a,b0

where
V = V u(b) + a (a)(J V ).
The FOCs are:


0 (a)(T P (V )) + P 0 (V ) 1 0 (a)(J V ) = 0
1 P 0 (V )u0 (b) = 0
Note that the second FOC again implies that P 0 (V ) < 0. This observation and the first FOC together imply that 0 (a)(J V ) < 1 for any a
satisfying the FOCs. Using the envelope theorem on the HJB equation
for P as before, we get
P 00 (V )V = (r )P 0 (V ).
Let (a , b ) (a (V ), b (V )) denote optimal effort and benefits. Differentiating the FOCs w.r.t. time and using this equation, we get
a =

0 (a )
(1 0 (a )(J V )) (r )
00 (a )

u0 (b )
b = 00 (r )
u (b )
Note the Euler equation for optimal benefits is the same as before and
also that
0 (a )
u0 (b )
<
0

>0
00 (a )
u00 (b )

OPTIMAL UNEMPLOYMENT INSURANCE IN CONTINUOUS TIME.

and

0 (a )(T P (V ))
>0
P 0 (V )
This means that r > implies a < 0 and b > 0, while r < implies
a > 0 and b < 0. Finally, in the case of equal discount rate, we get
a = b = 0. In that case, the vector (a , b , P ) is constant over time
and is determined by the system
1 0 (a )(J V ) =

V = u(b ) a + (a )(J V )
rP = b + (a )(T P )
0 (a )(J V + (T P )u0 (b )) = 1.
4. Non-verifiable effort.
In this section, we assume that exerted effort cannot be verified and
thus cannot be contracted upon directly. This implies that the optimal
contract must provide incentives for the agents to exert the prescribed
level of effort. Given a benefit schedule b b(V ), the unemployed
worker value V solves:
o
n
V = sup u(b) a + (a)(J V ) + V .
a0

The incentive compatibility condition is thus:

1 0 (a)(J V ) = 0.
Note that this already implies that the first-best level of effort obtained
in the last section cannot be implemented without verifiability. The
government agency now solves
n
o
rP (V ) = sup b + (a)(T P (V )) + P 0 (V )V .
a,b

To solve the problem we write the following Lagrangian



L = b + (a)(T P (V )) + P 0 (V )V + 0 (a)(J V ) 1 .
The FOCs are:
L
= 0 (a)(T P (V )) + P 0 (V )(1 0 (a)(J V )) + 00 (a)(J V ) = 0
a

OPTIMAL UNEMPLOYMENT INSURANCE IN CONTINUOUS TIME.

L
= 1 P 0 (V )u0 (b) = 0
b
Note that the FOC for b is still the same as before. However, optimal
benefits will be influenced by the presence of the IC through the effect
of the solution multiplier on the shape of P (V ). Simplifying the
first FOC, we get explicitly
=

0 (a )(T P (V ))
> 0.
00 (a )(J V )

Using the envelope theorem on the HJB equation for P , we now get
P 00 (V )V = (r )P 0 (V ) + 0 (a ).
Thus, even in the case r = , we must have V 6= 0, which implies that
a constant benefits policy cannot be optimal unless r exceeds by a
high enough magnitude. Differentiating the FOC for b, we again get:
P 00 (V )V u0 (b ) + P 0 (V )u00 (b )b = 0.
Rearranging and using the expressions we had for P 00 (V )V and P 0 (V ),
we get


0
00
0
b = P (V )V u (b ) = (r 0 (a )u0 (b )) u (b ) .
P 0 (V )u00 (b )
u00 (b )
This shows formally that r implies that the optimal benefit schedule is decreasing over time. The law of motion for a whenever V < J
is given by
0 (a )V
a = 00
.
(a )(J V )
This means that effort increases as the promised value for the agent
decreases.
References
Hugo A. Hopenhayn and Juan Pablo Nicolini. Optimal unemployment
insurance. The Journal of Political Economy, 105(2):412438, 1997.