Using a stochastic job model, Riccardo Welters and Joan Muysken show that employers use employment status as a screening device to minimize hiring costs.
The implied exclusion of long-term unemployed in hiring decisions might lead to market failures. These market failures can be corrected by employment subsidies for long-term unemployed. Firms can use the subsidies as compensation for extended search among long-term unemployed or to school these unemployed. In both cases the design of the employment subsidy should be different. When firms extend their search process, the level of the subsidy should depend on unemployment duration, whereas the subsidy should be uniform when the firm uses it to school unemployed.