The Costs of Unemployment

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When workers become involuntarily unemployed, there are several costs associated which they will unquestionably have to bear. These could come from the fact that there are certain firm-specific skills that an individual has, thus leading to scarce opportunities for individuals searching for jobs matching their specific skills (Lazear, 2003). Moreover, the costs could be associated with the model proposed by Harris and Holmstrom (1982), in which they stated that the workers have to be assumed to be risk averse and of unknown productivity or capability, meaning, only through experience the employers can really know about an employee’s productivity, and so, in an unemployment context, there is a lack of information regarding this.

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Furthermore, the costs could also come from large expenses in the process of searching for a new job (Mortensen, 1986). Several other labor market frictions can also be associated with the costs borne by the workers.

Owing to the high costs of unemployment present when a worker is involuntarily let go, both the worker and the firm will suffer substantial changes in their behavior. Previous literature found that, for the worker to be willing to bear the risks of unemployment, he or she will require an extra compensation which could take the form of higher wages, better working conditions or several extra benefits. This extra compensation is generally specified as compensating wage differential. Firms must, therefore, compensate the workers ex ante to bear the nontrivial costs of unemployment. More precisely, Abowd and Ashenfelter (1981) presented a model in which they proved that there is a competitive equilibrium wage rate which will vary according to the unemployment risk, concluding that the compensating wage differential varies across industries and is larger the higher the risk. Similarly, Topel (1984) found strong evidence that unemployment insurance (UI) benefits have a significant impact on both wage differences and unemployment. More authors, such as Hamermesh and Wolfe (1990), while approaching it differently, have focused on this same idea that the workers must gain a premium to bear the risk of unemployment. The two authors also found strong evidence that a large percentage of differences in wage differentials (from 14% to 41%) can be attributed to the divergences existing in unemployment risk between industries. Several authors have studied this subject looking at it in different ways, although all of them have reached similar conclusions.

The size of the premium mentioned above will be higher, the higher the risk. One can say that an increase in risk can be associated not only with a higher probability of unemployment in a given firm, but also, with an increase in the costs incurred by workers during an unemployment spell, as well as the higher the worker’s degree of risk aversion.

A crucial matter for this paper is whether or not these compensating wage differentials, associated to the unemployment risk, affect the firm’s financing decisions. Though, one could look at this in another perspective, i.e., what if an increase in the leverage of the firm has an impact in the unemployment risk? An increase in the financial leverage of a company will have an impact on the company’s probability of entering into financial distress. As previously studied by several authors, Ofek (1993) found that a firm’s response to financial distress has several dimensions, one of which being employee layoffs. Since a company in financial distress usually has to lay off workers so as to be able to meet its debt obligations, this will lead to an increase in the workers’ exposure to lay off risk. Given this, it is reasonable to assume that if a firm raises its levels of leverage, the costs associated with the compensating wage differentials will also increase, owing to the increase in the risk the workers will have to bear. Despite this conclusion, this paper goes the other direction. The aim is therefore to understand what is the impact, if any, the unemployment risk has on the firm’s financing decisions.

The trade-off theory, which is the traditional theory of capital structure and the one in which this paper will be focused on, stresses the existence of an optimal level of equity capital and debt. This ideal level between equity and debt can only be achieved by a balance between tax benefits and the costs of financial distress (Kraus and Litzenberger, 1973). In accordance with Myers (1984), a firm following this strategy will have to set an ideal debt-to-value ratio and then continuously move towards the goal. As stated in this theory, the total value of a levered firm will be equal to the total value of an unlevered firm plus the present value of the tax shields the firm will get from debt, less the present value of the costs of financial distress. In other words, the net present value of a debt issue will equal the net present value of the tax shields plus the net present value of the costs of financial distress.

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