Why Do New Technologies Complement Skills? Directed Technical Change and Wage Inequality

This paper considers an economy where skilled and unskilled workers use different technologies. The rate of improvement of each technology is determined by a profit-maximizing R&D sector. When there is a high proportion of skilled workers in the labour-force, the market for skill-complementary technologies is larger and more effort will be spent in upgrading the productivity of skilled workers. An implication of this theory is that when the relative supply of skilled workers increases exogenously, the skill premium decreases in the short run, but then increases, possibly even above its initial value, because the larger market for skill-complementary technologies has changed the direction of technical change. This suggests that the rapid increase in the proportion of college graduates in the US labour-force may have been causal in both the decline in the college premium during the 1970s and the large increase in inequality during the 1980s. The paper also derives implications of directed technical change for residual wage inequality and shows that calculations of the impact of international trade on inequality that ignore the change in the direction of technical progress may be misleading.