Wage inequality has increased dramatically in the United States over the last few decades. This change is reflected in movements in both between and within-group inequality. Throughout most of the 1980s, between and within-group inequality increased simultaneously. However, this pattern changed in the late 1980s. While between-group inequality continued to increase, measures of within-group inequality by education group have diverged. Lemieux (2006) documents that within group inequality increased for college graduates and postgraduates, remained constant for workers with high school diplomas and some college education, and decreased for high school dropouts. As we argue below, these patterns of within-group inequality are difficult to explain in standard competitive models of the labor market. However we show that a simple frictional model is able to explain these trends and moreover, is consistent with the movements in between-group inequality.
In understanding wage inequality most papers use a competitive framework where wages equal the marginal product of the worker. In these models between-group inequality reflects the price and distribution of observed skills, while within-group inequality reflects the price and distribution of unobserved (to the econometrician) skills. Katz and Murphy (1992), Krueger (1993) and others, use the competitive framework to explain the changing nature of inequality with a focus on skill biased technical change. But these early papers in the inequality literature were mainly motivated by movements in between-group inequality.
Lemieux (2006) points out that standard accounts of skill-biased technical change have difficulty reconciling the divergence in within-group inequality by group. If skill-biased technical change increases the price of unobserved skill, then within-group wage inequality should increase for all groups. Although this pattern was observed during the 1980s, it breaks down in the post-1990 period. More complicated models with multi-dimensional unobserved skill can explain these facts, but rely upon multiple price movements and/or changes in unobserved skill distributions varying by worker type. Such explanations are inherently difficult to test, and they may not capture how within-group inequality is related to between-group inequality through changes in technology.
There is a second dimension along which competitive models of skill-biased technical change struggle to explain movements in within-group wage inequality. We typically think of changes in the price of unobserved skills in response to skill-biased technical change as being persistent. And if unobserved skills are constant across individuals, or only changing slowly, then the competitive model suggests that the increase in within-group inequality should largely reflect persistent differences in wages across individuals over time. But, the existing empirical evidence suggests the opposite. Gottschalk and Moffitt (1994) and Kambourov and Manovskii (2009) show that much of the increase in within-group inequality has been transitory.
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Skill Requirements, Search Frictions and Wage Inequality
