There is no doubt that absent moral hazard, insuring against unemployment shocks is welfare improving. But moral hazard, either through the unemployed not searching hard enough or rejecting job offers, can have a vicious effect on welfare if it is sufficiently widespread and successful. In addition, as unemployment insurance contributions typically do not depend on unemployment risk, only bad risks want to participate, and the insurance collapses without mandatory participation. With all this in mind, does it make sense to implement unemployment insurance in developing economies, where there is a large informal sector that makes mandatory contributions difficult to enforce and where moral hazard is, of course, rampant?
David Bardley and Fernando Jaramillo show that introducing unemployment insurance actually makes the formal sector more attractive and that we should thus not worry that much about the current level of informality. The presented model, however, does not allow for someone to collect UI benefits while working in the informal sector, a very real possibility that could easily overturn the results.