Figure 1 reflects several well-known empirical regularities. First, unemployment decreases
with education (see e.g. OECD, 2004). Second, long-term unemployment is more prevalent
among low-skill workers. Human capital, i.e. productivity, can be so low that the best available
choice is to live on the dole permanently. In our model, this is in particular the case when labor
markets currently are and will remain tight (high λ0 and λτ), and when social benefits (s) are
3
generous.3
Education and employment go hand in hand, according to the empirical literature. For ex-
ample, Nickell (1979) and Machin and Manning (1999) show that unemployment duration falls
with education. Yet, in our setup becoming LTU means a complete exit from the labor force.
In other words, the decision to participate in the labor market again (triggered, for example, by
a change of welfare assistance, labor market tightness, or taxation) affects labor supply at the
extensive margin. Our result that LTU is - ceteris paribus - observed for people with low skills
and low productivity is in line with the empirical regularity that extensive labor supply elastic-
ities are particularly large at the low end of the income distribution (Eissa and Liebman, 1996
and Meyer and Rosenbaum, 2001). A positive relationship between education and participation
rates is also documented in OECD (2004).
On the upper end of the education spectrum we find those workers who never prefer to be
unemployed because the opportunity costs of unemployment (in terms of human capital degra-
dation and future wage loss) are too high. For intermediate skill-levels short-term unemployment
is optimal if hA is located to the left of hc - as shown in Figure 1 (see appendix for the case
without STU). For the STU it pays to let human capital erode if unemployment benefits are rel-
atively generous, if human capital does not erode much, or if the unemployment spell is actually
used to retrain and to upgrade human capital.
STU can be optimal for both persons who intend to retrain as well as for those who intend
to let human capital erode. STU always prevails when retraining pays off, i.e. when (5) holds.
These persons find it optimal to retreat from the labor market to acquire additional human
capital (think of someone taking an MBA). In order to obtain the condition for STU without
3 Note that we compare income streams and do not consider how utility is affected by time availability - be it
positively via leisure or negatively via reduced self-esteem. See Darity and Goldsmith (1996) for an overview on
the effects of joblessness on emotional well-being.