Wage-distance regulation in social-welfare programs: An option-theory perspective

It is often argued that low-skilled workers have an incentive to escape to the unofficial sector if welfare benefits come too close to the net wage in the official sector. Upper limits of welfare benefits often serve as an instrument to ensure a sufficiently high income differnetial between sectors. However, if unofficial-sector income is insecure, and if a change of sectors is costly, an option value of working in the official sector has to be taken into account. This option value reduces the incentive for lowly skilled workers to give up official-sector jobs. Upper limits of welfare benefits might therefore be defined less restrictively.