Wages and Employment in Perfect Competition

Study this chapter to learn about labor markets, including topics on wage differentials, discrimination, and unions.

4. Labor Markets at Work

4.1. Case in Point: Technology and the Wage Gap

Economist Daron Acemoglu's research begins by noting that the college premium, defined as the average wages of college graduates relative to that of high school graduates, rose 25% between 1979 and 1995 in the United States. Also, during essentially the same period, wage inequality rose. Whereas in the early 1970s, a person in the 90th percentile of the wage distribution earned 266% more than a person in the 10th percentile earned, 25 years later the gap had increased to 366%. The consensus view maintains that the increase in the college premium and in wage inequality stem primarily from skill-biased technological change. Skill-biased technological change means that, in general, newly developed technologies have favored the hiring of workers with better education and more skills.

But while technological advances may increase the demand for skilled workers, the opposite can also occur. For example, the rise of factories, assembly lines, and interchangeable parts in the nineteenth century reduced the demand for skilled artisans such as weavers and watchmakers. So, the twentieth century skill-bias of technological change leads researchers to ask why recent technological change has taken the form it has.

Acemoglu's answer is that, at least in part, the character of technological change itself constitutes a response to profit incentives:

The early nineteenth century was characterized by skill-replacing developments because the increased supply of unskilled workers in the English cities (resulting from migration from rural areas and from Ireland) made the introduction of these technologies profitable. In contrast, the twentieth century has been characterized by skill-biased technical change because the rapid increase in the supply of skilled workers has induced the development of skill-complementary technologies.

In general, technological change in this model is endogenous - that is, its character is shaped by any incentives that firms face.

Of course, an increase in the supply of skilled labor, as has been occurring relentlessly in the United States over the past century, would, other things unchanged, lead to a fall in the wage premium. Acemoglu and others argue that the increase in the demand for skilled labor has simply outpaced the increase in supply.

But this also begs the why question. Acemoglu's answer again relies on the profit motive:

The development of skill-biased technologies will be more profitable when they have a larger market size - i.e., when there are more skilled workers. Therefore, the equilibrium degree of skill bias could be an increasing function of the relative supply of skilled workers. An increase in the supply of skills will then lead to skill-biased technological change. Furthermore, acceleration in the supply of skills can lead to acceleration in the demand for skill.

It follows from this line of reasoning that the rapid increase in the supply of college-educated workers led to more skill-biased technologies that in turn led to a higher college premium.

While these ideas explain the college premium, they do not address why the real wages of low-skilled workers have fallen in recent decades. Popular explanations include the decreased role of labor unions, the increased role of international trade, and immigration. Many studies, though, have concluded that the direct impacts of these factors have been limited. For example, in both the United States and United Kingdom, rising wage inequality preceded the decline of labor unions. Concerning the impact of trade and immigration on inequality, most research concludes that changes in these areas have not been large enough, despite how much they figure into the public's imagination. For example, according to economists Aaron Steelman and John Weinberg, immigration accounted for a 2 million person increase in the labor force in the 1970s, when the baby boom and increased labor force participation of women added 20 million workers. During the 1980s, immigration was relatively high but still only accounted for a one percentage point increase, from 7 to 8%, in immigrant share of the total labor supply. While Acemoglu accepts those conclusions, he argues that labor market institutions and trade may have interacted with technological change to magnify technological change's direct effect on inequality. For example, skill-biased technological change makes wage compression that unions tend to advocate more costly for skilled workers and thus weakens the "coalition between skilled and unskilled work that maintains unions". Likewise, trade expansion with less developed countries may have led to more skill-biased technological change than otherwise would have occurred.

Acemoglu recognizes that more research is needed to determine whether these indirect effects are operating and, if they are, the sizes of these effects, but looking at how technological change responds to economic conditions may begin to solve some heretofore puzzling aspects of recent labor market changes.

What is to be done, if anything, about widening inequality? Steelman and Weinberg argue, "First, do no harm". They state,

Increased trade with LDCs and immigration from abroad likely have had little effect on wage inequality, while almost certainly adding to the strength and vitality of the American economy. Efforts to slow the growth of foreign goods or labor coming to our shores would be costly to Americans as a whole, as well as to those people who seem to be hurt by globalization at present.

However, they do suggest that policies to promote acquisition of skills, especially in early education where the return seems especially high, may be useful.