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.
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