Patterns of Skill Premia

Abstract

This paper develops a model to analyse how skill premia differ over time and across countries, and uses this model to study the impact of international trade on wage inequality. Skill premia are determined by technology, the relative supply of skills, and trade. Technology is itself endogenous, and responds to profit incentives. An increase in the relative supply of skills, holding technology constant, reduces the skill premium. But an increase in the supply of skills over time also induces a change in technology, increasing the demand for skills. The most important result of the paper is that increased international trade induces skill-biased technical change. As a result, trade opening can cause a rise in inequality both in the U.S. and the less developed countries, and thanks to the induced skill-biased technical change, this can happen without a rise in the relative prices of skill-intensive goods in the U.S., which is the usual intervening mechanism in the standard trade models. This paper develops a tractable model linking skill premia (returns to skills) to relative supplies, technology, and trade. The main innovation of the model is to treat the degree of skill bias of technology, and hence the demand for skills, as endogenous, and relate it to the supply of skills and to international trade. I show that this framework is broadly consistent with the time-series evidence on the evolution of the relative supplies and the skill premium in the U.S., and crosscountry differences in skill premia. It also suggests that increased international trade could be a major cause of the increase in wage inequality because it induces skill-biased technical change.