Market Failure in Unemployment Benefits Essay

Market failure occurs when resources aren’t used efficiently. This can be seen in any market, whether a publics good or a private good. Market failure can also be seen in the provision of unemployment benefits and unemployment insurance, as the resources could be used inefficiently and misused in different ways. For the purpose of this essay I will focus on how MORAL HAZZARD, prevents the efficiency in unemployment benefits and insurance, I will discuss the main issues to do with moral hazard in unemployment and also ways of combating it.

I will do this by firstly defining market failure and the main components on it before leading to the actual topic of moral hazard. Market failure usually occurs when markets operating without government intervention, fail to deliver an efficient or optimal allocation of resources. This means economic and social welfare will not be maximised, leading to a loss of production efficiency. It can also be defined as the inability of an unregulated market to achieve efficiency in all circumstances. There are three types of situation in which market failures arises:

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1. Provision of goods and services that we consume in common with everyone else 2. Production of goods where external costs or external benefits are present. 3. Restriction of output by monopolies and cartels. Existence of Market failure is often used as a justification for the government to intervene. Government interferes with the economy to redistribute wealth and income. This redistribution is justified as a basis of some notion of equity or distributive justice. The public interest theory states that the government predicts that action will take place to eliminate waste and achieve efficient allocation of resources.

The theory also states that when there is market failure government actions can be designed to eliminate the consequences of that failure to achieve allocative efficiency. Unemployment benefit is a public good which the government pays subsidies on for its provision. A public good is a good or service each unit of which is consumed by everyone and from which no-one is excluded. It is non-rival this means one person’s consumption doesn’t reduce the amount available for the next. It’s non-excludable which means there is no sort of discriminatory actor involved. Everyone is entitled to it when needed. Unemployment is an increasing factor in our society, with a 14. 2% unemployment rate recorded by the CSO in 2012. This means there is a large number of people availing of cash benefits which they do not pay for. These people are called free riders a free rider is someone who consumes a good without paying for it. A person receiving unemployment benefit is a free rider as due to the fact that they are unemployed they are unable to pay taxes which provide these benefits.

A free rider problem will arise as certain people are not willing to pay. This means tax payers who provide revenue for the provision of these services will have a huge burden than those who don’t. Tax payers bear the cost of aggregate risk which results in inefficient allocation. Economist Paul Krugman described moral hazard as “any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly”. [Moral hazard is the tendency to take unnecessary risks as the penalties of those risks are not borne by you.

In turn one party makes a decision on how much risk to take while the other suffers the consequences of the risk. This means the individual is not taking full responsibilities for his or her action. Moral hazard is a special case of asymmetric information as one person has more information that the other. The person with more information acts in a way which suits him/her. For a market to be efficient consumers and producers must have full information about prices, quality and about the future.

Individuals have some sort of control on whether they choose to be employed or not. The insurer isn’t sure of the probability that the unemployed will or is actively looking for work. Moral hazard is greatly seen as an individual can influence their probability of entering or leaving unemployment. Moral hazard creates a disincentive to work and reduces the supply of labour in a country. Moral hazard is unobservable , this means the providers of insurance and benefit are totally unaware of the unemployed intention while receiving the benefit.

In unemployment insurance the two parties are involved in contractual relationships, as their intentions contradict. The receiver of the benefit is acting in a hazardous way and the insurer is fully on aware which makes the provision a market failure. The money being received for unemployment benefit is substantially high in Ireland. This means that people are less willing to look for work as they have a good income already. Looking for work would mean a loss of benefit or a reduce income due to tax which will reduce the incentive for a person to go look for work.

Due to Moral Hazzard the system of payment are structured with a view to ensuring that the system of payments does not weaken the incentive of the unemployed to take on paid employment. Income tax and social security contributions levied on earnings determine the employee’s net earnings, when unemployed a worker receives payments. If the gap between this is too much it may affect the incentive to work. If the ratio is high then moral hazard increases as those who are unemployed may cease to work.

Workers may also work fewer hours or quit due to the high level of payment and also the duration of time a person is able to receive the benefit. There is a moral hazard in provision of unemployment benefit also as it raises the unemployment duration. This is a substitution effect caused by distortion in the price of leisure relative consumption which also leads to moral hazard. Moffit (1985) and Meyer(1990) have shown that a 10% increase in unemployment benefit causes an average unemployment duration by 4-8% in the U. S. Combating: The disincentive can be reduced by varying benefits.

It’s obvious that moral hazard only occurs in this situation due to the fact that the benefits received is high. This means the person is less motivated to look for work as they know they are getting a high amount of money for not being in employment. The person is not willing to sacrifice his or her leisure time to get employment. This would impose an opportunity cost for the person. Therefore in order to increase the incentive there has to be a reduction of payments. This would make the person eager to seek employment as they are on low incomes which decreases their standard of living.

With government intervention the gap between labour income and unemployment benefits can be increased to motivate individuals to seek work. Also if the tax on income is reduced it could act as an incentive to work and discouraging people to get off the benefits. The duration of time spent on the register for benefits should also be reduced. If government is able to impose a strict code of conduct on the duration of time which benefits can be given it will increase people’s willingness to work. Government intervention in the form of penalties for long term users of benefits should be impose, leading to a cut in benefits.

Better information should be provided in order to be able to note those who are actively seeking work and those who aren’t and failure to obey the rules may lead to a cut in payments. To conclude the provision of high benefit, leads to moral hazard as people have a disincentive to work. The lengthening of the unemployment duration by the substitution effect creates a moral hazard. It may be said that unemployment benefits raises the occurrence of moral hazard. Therefore reduction in benefits and duration of time should be reduced in order to combat moral hazard. This will erase market failure and lead to a more efficient system.

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