SKILL PREMIUM THROUGHOUT THE AGES

By Rui Luo

How do economic growth and technological change affect inequality? The skill premium (the wage of skilled labour relative to that of unskilled labour) is one good reflection of the interrelation between growth, technological change and inequality. Existing studies show that skill-biased technological change (SBTC) contributes to the rising skill premium in modern days. But few studies have been made on the skill premium in the past and its relation with technological change.

My research takes a look at the skill premium in a very long historical period. As can be seen in Figure 1, the skill premium in Western Europe declines from a level of 140 per cent in 1300 to a low level of approximately 55 per cent by 1600 and remains stable at the low level afterwards.

Figure 1: The evolution of the skill premium in Western Europe from 1300-1914

My research focuses on the period from 1300 to 1850, the pre-modern era. Economic growth is slow and sometimes standstill. Technological change is intermittent—not as persistent as it is today. Determining how pre-modern growth and technological change shape the ‘’first declining, then stable’’ pattern of the skill premium is the aim of my research.

The findings

I develop a model that reflects the economic growth and technological change in this period. In this model, production is conducted in two different sectors. The first sector hires physical capital (henceforth, capital) and skilled workers, each of whom supplies some units of human capital, for production. The second sector adopts land and unskilled workers for production. Individuals have to make human capital investment (i.e. pay training fees) to become skilled labour. Technological change is featured with growing land productivity.

Using this framework, I find that the capital-human capital ratio (i.e. how abundant physical capital is relative to human capital) and the human capital investment (the amount of training fees individuals are willing to pay) determine the skill premium. They have competing effects: increasing the ratio of capital over labour reduces the skill premium but growing investment in training raises it. Which effect dominates the other depends on whether the ratio is above or below a certain level.

The increase in the ratio of capital over labour always reduces the skill premium, but sometimes, while the ratio is increasing, its level stays below a certain threshold. For instance, let the threshold be 3. As the ratio grows from 1 to 2, its level is still below the threshold 3. In this case, the premium reduction it causes is more than the possible premium increase caused by growing investment in training. In the final balance, the skill premium declines. Now, when the ratio becomes sufficiently high, going beyond the threshold, the premium reduction it causes cancels out with the premium increase incurred by growing investment in training. The premium becomes stable.

As the capital-human capital ratio grows from an initially low level to a sufficiently high level, it interacts with human capital investment in two different ways. We can then partition the process of development into two regimes. And the evolution of the skill premium in these regimes is:

  1. In the first regime (1300-1500), the capital-human capital ratio is low. Human capital investment stays low and fixed. The growing capital-human capital ratio has a dominant and negative effect on the skill premium. The skill premium goes down;
  2. In the second regime (1500-1850), the capital-human capital ratio grows to a sufficiently high level. Human capital investment starts growing along with the capital-human capital ratio. And their competing effects cancel out. The skill premium stays stable.

Which regime the economy is in depends on the ratio of capital over labour. It is initially low, when the economy is in the first regime. Over time, technological change raises this ratio from an initially low level to a sufficiently high level. The economy shifts from the first regime to the second regime. As the two points above indicate, the skill premium declines while the economy is in the first regime, and stays constant as the economy goes into the second regime.

Interpretation of the findings and conclusion

We can take an intuitive look at the mechanism in which pre-modern technological change brings the skill premium down to a low and stable level. Examples of pre-modern technological change are the invention of fertilisers, the improvement of irrigation systems and the introduction of new ways of production (i.e. replacement of field with ranch).

These new technologies raise the productivity of land and do not require skills to operate. This makes it more attractive for individuals to work as unskilled labour. However, technological change raises people’s willingness to pay for training to become skilled. This raises the productivity of skilled labour (i.e. more human capital supplied by each skilled worker). And the number of skilled workers needed to carry out the same task decreases.

Overall, technological change favours unskilled over skilled labour and it changes the structure of society: it makes working as an unskilled labourer more favourable, which results in a larger fraction of the population doing unskilled work. It is such a change that brings the skill premium to a low and stable level.

The main feature of modern Europe is the creation of technology that is operated by a large number of unskilled workers, which enables mass production. This is similar to the pre-modern technological change that brought the skill premium in Western Europe to a low and stable level. It can then be concluded that behind the ‘’first declining and then stabilising’’ pattern of the skill premium is the shaping of modern Europe. Technological change triggers economic growth and transition so Western Europe resembles more to what it is today. The skill premium becomes steadily low as Western Europe becomes more ‘’modern-like’’.

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