This paper derives optimal employment contracts when workers are risk averse and there are
employment and unemployment risks. Without income insurance, consumption rises during
employment and falls during unemployment. Optimal employment contracts offer severance
compensation and sometimes give notice before dismissal. Severance compensation
smoothes consumption during employment but dismissal delays insure partially against the
unemployment risk because of moral hazard. During the delay consumption falls to give
incentives to the worker to search for another job. No dismissal delays are optimal if
exogenous unemployment compensation is sufficiently generous.
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