The Rise of the Machines: Automation, Horizontal Innovation and Income Inequality

Persistently increasing wage inequality, polarization of the wage distribution, and stagnating real wages for low skill workers are some of the most salient fea-tures of modern labor markets, but are difficult to reconcile with the theoretical literature on economic growth. To better understand the mechanisms driving these phenomena, we construct an endogenous growth model of directed technical change with automation (the introduction of machines which replace low-skill la-bor and complement high-skill labor) and horizontal innovation (the introduction of new products, which increases demand for both types of labor). The economy endogenously follows three phases: First, both low-skill wages and automation are low, while income inequality and the labor share are constant. Second, increases in low-skill wages stimulate investment in automation, which depresses the growth rate of future low-skill wages (potentially to negative), and reduces the total la-bor share. Finally, the share of automated products stabilizes and low-skill wages grow at a positive but lower rate than high-skill wages. Adding middle skill work-ers allows the model to generate a phase of wage polarization after one of uniform increase in income inequality. We show that this framework can quantitatively account for the evolution of the skill premium, the skill ratio and the labor shar