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INSEAD Working Paper 2014/61/EPS
We construct an endogenous growth model of directed technical change with automation (the introduction of machines which replace low-skill labor and complement high-skill labor) and horizontal innovation (the introduction of new products, which increases demand for both types of labor). Such an economy endogenously follows three phases. First, low-skill wages are low, which induces little automation, such that income inequality and labor's share of GDP are constant. Second, as low-skill wages increase, investment in automation is stimulated, which depresses the future growth rate of low-skill wages (potentially to negative), and reduces the total labor share. Finally, the share of automated products stabilizes and the economy moves toward an asymptotic steady state, where low-skill wages grow but at a lower rate than high-skill wages. This model therefore delivers persistently increasing wage inequality and stagnating real wages for low skill workers for an extended period of time, features of modern labor markets which have been difficult to reconcile with the theoretical literature on economic growth. We further include middle-skill workers, which allows the model to generate a phase of wage polarization after one where labor income inequality increases uniformly. Finally, we show that an endogenous labor supply response in this framework can quantitatively account for the evolution of the skill premium, the skill ratio and the labor share in the US since the 1960s.