Neoclassical production, scarcity of skills and Pareto distributions

Abstract

The distribution of top earnings follows a “power-law”: the top tail of the distribution is thick relative to other distributions and is approximately Pareto-distributed. There are different mechanisms proposed in the literature that yield Pareto distributions and power-laws. This paper shows that a simple general equilibrium model where aggregate production is assumed of the constant-elasticity-of-substitution (CES) type over multiple labor inputs generates distributions in earnings and wages that follow power-laws. The finding is very general as the distribution of the skill-types is irrelevant for the shape parameter (the Pareto exponent) of the power-law. The model displays a tight relationship between the Pareto exponent and the elasticity of substitution between the labor inputs. Available empirical estimates of the elasticities of labor substitution and of the labor supply predict a Pareto exponent consistent with its empirical counterpart for the distribution of earnings in the US.