can differ substantially because generous benefits discourage search by highly skilled workers
who suffered a loss of human capital while unemployed. Thus, Ljungqvist and Sargent also
identify institutional characteristics to be responsible for the European unemployment problem.
Their explanation of unemployment change, however, is based on increasing skill degradation
(turbulence). While Ljungqvist and Sargent’s initial hypothesis is challenged by the observation
that there were indeed considerable institutional changes within and across European countries
over the last 30 years, the central theoretical argument that faster skill degradation may cause
or aggravate long-term unemployment remains of course valid.
We adopt the idea that the endowment with human capital and its degradation when not
employed are crucial factors in the determination of long-term unemployment. We then proceed
by investigating how particular institutional variables affect the decision to remain short- or
long-run unemployed and to mitigate skill degradation by retraining.
Skill degradation is frequently invoked as an intuitive explanation of hysteresis in unemploy-
ment. It complements other explanations based on insider-outsider effects of wage determination
(Lindbeck and Snower, 1988), habit formation (Vendrik, 1993), and stigmatization or scarring
effects. See Roed (1997) and Cahuc and Zylberberg (2004) for overviews and Bean (1994) for a
critical comparison of supply- and demand-side mechanisms in explaining European unemploy-
ment and its persistence. Demand-side effects of skill loss during unemployment are investigated
by Pissarides (1992) and Coles and Masters (2000).
We investigate supply-side effects of human capital degradation on (long-term) unemployment
as in Ljungqvist and Sargent (1998). Methodologically, however, we use a different approach.
Instead of solving a complicated general equilibrium model of search and matching numerically
we focus on the labor supply- and retraining-decisions of currently unemployed persons. This
micro-economic focus enables us to solve the problem analytically and to present comparative
statics in a simple diagrammatic exposition. Our analytical approach builds on human capi-
tal theory and investigates how the unemployed react to incentives with respect to retraining
and, in particular, the time spent ”on the dole”. We assume that workers’ earnings depend
on their skills, that these skills deteriorate while unemployed but that skill degradation can be
mitigated by retraining. These incentives are shaped by the interplay of labor market insti-
tutions, socio-economic characteristics of the unemployed and labor market performance. Our
approach enables us to investigate a broad range of factors. The institutional factors we analyze