Optimal Severance Pay in a Matching Model

This paper constructs an equilibrium matching model with risk-averse workers and incomplete markets that can be used to study both the optimal private provision of severance pay and the allocational and welfare consequences of government intervention mandating payments in excess of the private optimum. A binding mandate decreases equilibrium employment if unemployment benefits are not too responsive to wages, and increases it otherwise. In the latter case, the increase in employment can be substantial for values of the unemployment benefit replacement rate at the upper end of its range in OECD countries. JEL classification: J23, J64, J65.