Social Security, Unemployment Risk and Efficient Bargaining between Unions and Firms

We construct an overlapping generations model with unemployment risk where wages, employment and severance payments are set through efficient bargaining between risk averse Unions and risk neutral firms. Assuming that a First Best cannot be achieved due to workers' shirking incentives, we characterize a Second Best allocation and show how this can be implemented in a market economy. We prove that the latter generates too little employment and consumption smoothing, an excessive young age consumption and too much saving with respect to the Second Best. This inefficiency can be reduced by increasing the intensity of a pay-as-you-go social security system even if the economy is dynamically efficient.