Academic journal article Federal Reserve Bank of Atlanta, Working Paper Series

Sector-Specific Human Capital and the Distribution of Earnings

Academic journal article Federal Reserve Bank of Atlanta, Working Paper Series

Sector-Specific Human Capital and the Distribution of Earnings

Article excerpt

Abstract: This paper incorporates assignment frictions and sector-specific training into the Roy model of occupational choice. Assignment frictions represent the extent of the market whereas differences in sector-specific training reflect worker specialization. This framework thus captures Adam Smith's idea that the extent of the market determines the division of labor. The paper demonstrates the way in which the relationship between assignment frictions and specialization affects the level and composition of human capital acquisition, aggregate output, and the distribution of income. Not surprisingly, economywide training, output, and specialization increase as the extent of the market increases. The distribution of these gains, however, is uneven. Within group or residual income, distribution does not converge monotonically as search frictions diminish. Comparisons across groups reveal that these effects can become more pronounced as average income increases.

JEL classification: E24, J24, D31

Key words: human capital, occupational choice, job assignment, income distribution

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Working Paper 2009-21

September 2009

"There are some sorts of industry, even of the lowest kind, which can be carried on no where but in a great town.... In the lone houses and very small villages which are scattered about in so desert a country as the Highlands of Scotland, every farmer must be butcher, baker, brewer for his own family.... The scattered families that live eight or ten miles distance from the nearest of them, must learn to perform themselves a great number of little pieces of work, for which, in more populous countries, they would call in the assistance of those workmen." (Adam Smith, The Wealth of Nations, p. 17)

Since Adam Smith if not before, the determination and distribution of labor market earnings have occupied the attention of economists. Recently, a vast literature has emerged establishing that earnings inequality in the US and elsewhere has grown dramatically over the last four decades. During the 1980's and 1990's inequality across groups deepened considerably while within group (or residual) inequality has also grown markedly since the 1970s. (See Katz and Autor, 1999, and Machin and van Reenen, 2007, for a survey and overview.) Although debate continues notably regarding the most recent trends (Card and DiNardo, 2002, Lemieux, 2006, Sattinger 2007), skilled biased technological change appears to be the most plausible cause for the rising spread in earnings across groups.

Unfortunately, skilled biased technological change, as well as other prominent explanations, offers little help in understanding the changes in residual wage disparity. (1) To address this shortcoming, this paper presents a model of earnings that incorporates labor market frictions and sector specific training into a Roy model of occupational choice. (2)

Suppose workers choose how much training to acquire for potential jobs before investigating and then choosing among available employment options in different occupations. Following Adam Smith's lead, the likelihood with which an agent trades in a particular occupation, modeled here through assignment frictions, reflects the extent of the market for different occupations. (3) Agents take account of these frictions in their choices. The extent of the market determines not only training investments and the degree of skill specialization but also the level and distribution of earnings. Matching outcomes affect the division of labor.

This simple set-up links market frictions with different levels of human capital investments as well as uncertain income outcomes. Total training and aggregate income all rise as the extent of the market increases, that is, as the market thickens and assignment becomes more certain. This result is not surprising; however, the composition of human capital alters the distribution of these gains. …

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