Capital-skill complementarity and inequality: A macroeconomic analysis

The supply and price of skilled labor relative to unskilled labor have changed dramatically over the postwar period. The relative quantity of skilled labor has increased substantially, and the skill premium, which is the wage of skilled labor relative to that of unskilled labor, has grown significantly since 1980. Many studies have found that accounting for the increase in the skill premium on the basis of observable variables is difficult and have concluded implicitly that latent skill-biased technological change must be the main factor responsible. This paper examines that view systematically. We develop a framework that provides a simple, explicit economic mechanism for understanding skill-biased technological change in terms of observable variables, and we use the framework to evaluate the fraction of variation in the skill premium that can be accounted for by changes in observed factor quantities. We find that with capital-skill complementarity, changes in observed inputs alone can account for most of the variations in the skill premium over the last 30 years.