Understanding Wage Inequality: Ben-Porath Meets Skill-Biased Technical Change

In this paper we present a tractable general equilibrium overlapping-generations model of human capital accumulation which is consistent with several key features of the evolution of the U.S. wage distribution from 1970 to 2000. The key feature of the model, and the only source of heterogeneity, is that individuals differ in their ability from all kinds of idiosyncratic uncertainty, and thus, wage inequality results only from differences in human capital accumulation. We examine the response of this model to skill-biased technical change (SBTC) both theoretically and quantitatively. First, we theoretically show that in response to SBTC, the model generates behavior consistent with the U.S. data including (i) a rise in total wage inequality, (ii) an initial fall in the education (skill) premium followed by a strong recovery, leading to a higher premium in the long-run, (iii) the fact that most of this fall and rise takes place among younger workers, (iv) a rise in within-group inequality, (v) an increase in educational attainment, (vi) stagnation in median wage growth (and a slowdown in aggregate labor productivity), and (vii) a rise in consumption inequality that is much smaller than the rise in wage inequality. We then calibrate the model to the U.S. data before 1970, and find that the evolution of these variables closely track their empirical counterparts during SBTC (from 1970 on). These results suggest that the heterogeneity in the ability to accumulate human capital is a key feature for understanding the effects of SBTC and interpreting the transformation that the US economy has gone through since the 1970’s