Business cycles, unemployment and welfare in contractual economies

This thesis analyzes two economic scenarios in which constraints to the enforcement of labor contracts force workers to bear imperfectly diversifiable risk. We study the resource allocations in such economies as well as the role of economic policy in ameliorating risk and in improving welfare.; The first essay shows how the seemingly small volatility of aggregate wages can hide a substantial amount of individual wage risk. The optimal contracts analyzed are such that workers bear the risk of being laid off when the market for new contracts is depressed. We fit this model to replicate the wage variability estimated from micro data and obtain a measure of the cost of business cycles substantially larger than previous estimates. We use this model to evaluate different labor market policies and find that unemployment benefits or employment subsidies that vary with the state of the economy can improve efficiency and reduce the cost of business cycles.; In a second essay, we extend the classical incentive contracting model to incorporate aggregate uncertainty and workers' risk aversion. In environments where firms have possibilities to diversify risk and can commit to contracts, equilibrium contracts are characterized by wage offers that insure workers against labor market downturns, but increase when workers' reservation values increase and shirking becomes more attractive. We fit this model to replicate a set of observations and study the cyclical properties of the equilibrium allocations.; Finally, in a third essay we analyze the economic effects and welfare implications of publicly funded unemployment insurance schemes. We find the results to be highly sensitive to the degree to which the insurer agency can observe the source of the unemployment spell. When dismissed workers qualify for unemployment subsidies, we find that reducing benefits reduces equilibrium wages, increases replacement ratios, and improves welfare. However, when the insurer has some means of discriminating among laid off and dismissed workers, unemployment insurance becomes an incentive device. By increasing the returns to effort, unemployment benefits reduce equilibrium wages, increase employment, and improve welfare.