One or Many Kuznets’ Curves?
Short Run and Long Run Effects of the Impact of Skill-Biased Technological Change on Income Inequality
by
Gianluca Grimalda
CSGR (Warwick University)
and
Marco Vivarelli
(Università Cattolica-Piacenza; ILO-Genève; IZA-Bonn)
First Draft
30th March 2004
This paper is part of a research project carried on at the International Labour Office, Internation Policy Group, Genève.
1.Introduction
“…Is the pattern of the older developed countries likely to be repeated in the sense that in the early phases of industrialization in the underdeveloped countries income inequalities will tend to widen before the leveling forces become strong enough first to stabilize and then reduce income inequalities?”(Kuznets, 1955, p.24).
In the last two decades, within country income inequality (WCII) has shown – despite some notable exceptions, e.g. Mexico, South Korea, Italy, and, including the 70s, Turkey - an overall increasing trend both in the developed and developing countries around the world (Sala-i-Martin, 2002: 4). Focusing the attention to developing countries (DCs), some areas of the world - namely Latin America, China and former Soviet Republics - have been markedly affected by increasing WCII while at the same time be involved in a rapid process of increasing globalization both in terms of trade and foreign direct investments.
On the theoretical side, standard trade theory, based on the Stolper-Samuelson corollary of the Heckscher-Ohlin theorem, actually predicts that in developing countries, where abundant unskilled labour is cheap, one should observe trade driving the demand for the unskilled-labour-intensive goods, thus decreasing WCII[1]. The main counter-argument to the Stolper Samuelson theorem is based on the skill-enhancing-trade hypothesis (Robbins, 1996, 2003) which points out that trade liberalization in DCs implies the importation of machinery from the North, leading to capital-deepening and (given capital-skill complementarities) to rising relative demand for skilled labour[2].
This argument is even stronger if the attention is focused on the possible role of the imported skill biased technological change (ISBTC) in determining an increasing wage premium in DCs. In particular, Berman and Machin, 2000 and 2004 present convincing empirical evidence about the diffusion of SBTC from the developed countries towards the middle-income DCs. Based on this literature, Vivarelli (2004) shows a significant impact of increasing import on the WCII, using a sample of 34 DCs who recently engaged in opening their economies to international trade.
This evidence opens the way to a reconsideration of the so-called Kuznets’ curve. Kuznets’ seminal analysis refers to the process of industrialisation and urbanisation that affects countries at their early stages of development. Kuznets’ “story” is that the shift of labour from the agricultural sector (where both per capita income and within sector inequality are low) towards the industrial/urban sector (which starts small, with higher per capita income and a relatively higher degree of within-sector inequality), results into an inverted U-shaped curve relating economic growth to WCII (Kuznets, 1955: Table 1, p.13; see also Kuznets, 1963)[3].
By fOnly focusing on developed countries, “new” growth theorists have argued that a similar type of non-linear dynamics should also occur as a consequence of a skill biased technological change (SBTC) (see Galor and Tsiddon 1996 and 1997; Aghion et al., 1999; Galor and Moav, 2000). The argument runs as follows. The introduction of a SBTC triggers an increase in skilled labour demand and of the skill premium, thus determining an increase in inequality and originating the first segment of the Kuznets’ inverted-U curve. Then, widening wage-gaps induce the unskilled to invest more in the formation of human capital through education, learning and training. Hence, as workers upgrade their skill levels, skilled labour supply increases thus reducing the skill premium and inequality, so originating the second segment of the Kuznets’ curve.
Although different accounts of the technological transition are consistent with this general idea[4], a Kuznets’ curve originates as a result of wages evolution and changes in the workforce composition. Hence, these theories explain the recent rise of WCII in developed countries in terms of the upward bit of the Kuznets’ curve, and predict an inequality-decreasing trend for the next years. The reason is that a period of 15-20 years from the original SBTC are seemingly sufficient for the inequality-decreasing forces to counteract the initial inequality-enhancing effect (Aghion et al (1999, p.1655).
In order to mark the differences between the two theoretical hypotheses above, we shall refer to the original Kuznets’ model as Kuznets I, whereas we shall call the latter Kuznets II. Though an identical pattern of WCII arises in the two settings, in fact, there obviously exist relevant differences as to their underlying causes and ways these affect other economic variables. First, Kuznets’ original story typically refers to secular transformations of a country’s economy, so that the time-scale for a complete cycle to occur may even take as long as a century[5]. The Kuznets II cycle originated by SBTC may instead be completed within a much shorter horizon, as suggested in the above paragraph. Second, countries that may be affected by a Kuznets II type of dynamics are typically high-income countries, or middle-income countries that have started a process of technological catching-up. Differently, Kuznets I typically only applies only to low-income countries in their earlier stages of development.This paper develops a theoretical dynamic model which can be used in interpreting the occurred rise in WCII in fast globalizing DCs (such as those mentioned above). It is a two sector model, close in nature to the numerical exercise conducted by Simon Kuznets, 1955 (Table 1, p.13) and resulting into an inverted U-shaped curve relating economic growth to WCII (see the quotation above).
However, unlike Kuznets’ model where results are the arithmetical consequence of a shift of labour from the agricultural sector (where both per capita income and within sector inequality are low) towards the industrial/urban sector (which starts small, with higher per capita income and a relatively higher degree of within sector inequality), our model is also based on the important distinction between skilled and unskilled labour (a general description of the model is provided in the following Section 2)[6]On the empirical level, Kuznets’ curve was commonly accepted in the ‘70s (see Ahluwalia, 1976), while more controversial results have been found in the following years (see Papanek and Kyn, 1986; Anand and Kanbur, 1993; Li, Squire and Zou, 1998). However, more recent studies have given further support to the law. For instance, in Barro (2000) Kuznets’ curve emerges as a clear and statistically significant regularity: the relationship between the Gini coefficient and a quadratic in log GDP turns out to be statistically significant in a SUR panel estimation based on a sample of 100 countries over the period 1965-95 (see Barro, 2000, Table 6, p.23) Similarly, Reuveny and Li (2003) have found a 5% significant support for the existence of a Kuznets’ curve using a sample of non-OECD countries over the period 1960-96.
On the basis of these studies, in this paper Kuznets’ curve is assumed as a stylized fact, whose underlying factors and mechanismsof transmission are investigated from a new theoretical point of view.and as a benchmark for the validity of the proposed theoretical model. In particular, our hypothesis is that the transfers of ISBTC towards middle-income developing countries can be considered as a trigger factor in determining an initial increase in WCII in those countries and so inducing the upward trend of a Kuznets II dynamics[7]). Hence, the departure from the steady state is here to be understood as the effect ofISBTC associated with opening to trade by a middle-income DC previously specialised in the use of a backward technology.
The theoretical framework is based on Silverberg and Verspagen (1994): it consists of a dynamical two-sector model characterised by increasing returns to scale at the sectoral level, which generates unbalanced growth and multiple steady states. The theoretical underpinnings of the model and the analysis of its steady states are presented in Section 2. In section 3 the initial conditions of the perturbed system are calibrated on real data from middle-income developing countries. In this section we show that the Kuznets II story - originally thought for developed countries (see above) - can be replicated with regard to middle-income countries engaged into a globalization process[8].
As an important novelty of this paper, The latter is aimed to represent the possible impact of ISBTC on WCII. Opening to trade is represented by a departure from the steady state and originates a pattern of WCII consistent with Kuznets’ law. However, unlike Kuznets’ story, the dynamics is not simply driven by the fact that the share of the modern sector in total employment goes from zero to unity, but also and mainly by the increase in the demand for skilled labour due to ISBTC by a DC previously specialised in the use of a backward technology (see Section 3). This new interpretation of Kuznet’s law hinges on movements in the supply of skilled labour (for a review see Aghion et al., 1999). The main idea is that the introduction of a skill-intensive technology brings about an increase in the wage premium (this is the initial portion of Kuznets’ curve). This has the effect of attracting cohorts of workers to the sector of the economy that has adopted the more advanced technology (in this version of the model, manufacturing as opposed to agriculture). In the longer run, this reallocation of labour supply across sectors of the economy offsets the initial excess of skilled labour demand and leads to a more equal income distribution (second portion of Kuznets’ curve).in Section 4, we put forward an account for the Kuznets’ law differing from the Kuznets II hypothesis discussed in Section 3. Whereas in the latter the Kuznets’ curve emerges as the result of a “progressive” dynamics of convergence towards the more advanced technology, we show An important variant of the model is carried out in Section 4 which also generates how a Kuznets’ curve can also be generated , but as a consequence of a “regressive” dynamics (as opposed to the “progressive” dynamics at the core of original Kuznets’ exercise and also present in the version of the model developed in Section 3), in which an advanced technology is initially introduced within the economic system, but then fails to diffuse and take over the backward technology in the longer run. In this version of the model, the initial situation of relative skill shortage is the key factor preventing the economy from undertaking the development path of convergence toward the high growth equilibrium. In fact, the skill premium is relatively high as a consequence of the skill shortage, so that firms do not find it profitable to invest in the advanced sector, and in turns workers have no incentive over time to invest in education, learning and training to upgrade their skills because of the lack in labour demand.
This can easily be the typical situation of those DC’s characterised by institutional constraints in their educational and training systems (including firms’ inability to provide on the job training and to develop an adequate HRM). As a result, the skill-intensive imported technology eventually fails to take-off because the condition of skill shortage persists over time, so that not only does the advanced technology fail to take over the backward technology as the leading one in the economy, but also it vanishes because productivity gains progressively fall if the technology is not sufficiently diffused within the economy. Hence, unlike the “progressive” case, the initial inequality-enhancing effect caused by the increase in the skill premium is here compensated by a decrease in skilled labour demand rather than through adjustments in skilled labour supply, and the long-run implication is one of failure rather than success in the catching-up process, i.e. a (“poverty trap” due to technological lock-in (see Atkinson and Stiglitz, 1969). We believe that this account may offer an explanation of recent WCII dynamics in those middle-income globalizing DCs which have opened to international trade but whose process of technological catching-up is stagnating (examples are most Latin American countries, some MENA - Middle East and North African - countries and previous Soviet Republics).
Finally, Section 5 is devoted to some concluding remarks.
2.The Model
2.1General features of the model
Three are the key assumptions of the model.
First, there exist a variety of sectors in the economy - two in its simplest version - that are associated with technologies having different degrees of skilled labour intensity. Their pattern of technical change is localised (Atkinson and Stiglitz (1969)) and it is assumed that productivity growth rates are positively related with the share of economic activity taking place within each sector. This implies that there are increasing returns to scale at the sectoral level.
The second basic assumption is that agents are boundedly rational (Simon, 1955; Nelson and Winter, 1982; Hogarth and Reder, 1986), so that the aggregate behaviour of individual choices follows a replicator type of dynamics (Weibull (1995)).
Finally, markets do not clear instantaneously, but prices evolve in accordance with the imbalances between demand and supply, and exchanges take place even outside equilibrium. Hence, the model can be thought of as a “disequilibrium” one. In particular, two labour markets, one for skilled and one for unskilled labour, are considered.
Consistently with these three basic assumptions, the main feature of the model is the possibility to generate multiple steady states; that is, both a high-growth and a slow-growth equilibrium exist, and convergence towards either of them is determined by the structural conditions of the economy. These include the size of the adjustment costs that workers and entrepreneurs have to undertake in order to ‘move’ to the alternative sector of the economy. In particular, not only the costs for the skill upgrade of the labour-force, but also those for entrepreneurs in relocating their productive activities, are taken into account. The slow-growth steady state can then arise even in the presence of flexible prices, when strongly adverse conditions to adjustment take place. This highlights the possibility that policies of liberalisation and opening to trade do not necessarily benefit the economy in the presence of a limited capacity of ‘absorbing’ more advanced technologies by the economic system (see next section).
Thanks to the dynamical nature of the analysis, which relies on computer numerical simulations, the initial transition phase can be investigated along with that of convergence toward a steady state. This enables us to analyse both the short-term and the long-term effects of a shock in the structural parameters of the model, such as the opening to international markets.
2.2A Formal Analysis
The basic assumption of the model is that each of the two sectors of the economy is associated with a particular technology, which differ from each other for their labour skill-intensity. In particular, the “modern” (“traditional”) sector of the economy is associated with a skilled-labour (unskilled-labour) intensive technology, which, for simplicity, exclusively requires skilled (unskilled) labour. Moreover, we assume that each technology is uniquely associated with a technique of production[9], so that labour and capital are used in fixed proportions. This enables us to take on a Leontief representation for each of the two sectoral production functions:
(1)
L1 and K1 (L2 and K2) represents the employment of skilled (unskilled) labour and capital in the skill-intensive (unskilled-intensive) technology. c is the fixed coefficient of the content of capital for one unit of output, assumed to be equal for the two technologies, whereas ai is labour productivity[10].
The present framework appears to be general enough to be applied to different contexts and to different stages of development of an economy. In particular, the modern and the traditional sector may be thought of as representing the industrial and the agricultural sector of a developing economy, so that the model may be applied to the study of the industrialisation and urbanisation process that actually motivated Kuznets’ seminal work (Kuznets I, see Section 1). However, the two sectors can also be thought of as the hi-tech and the low-tech sectors within the manufacturing sector of a middle-income or even a developed country. In this way, the model may describe the transition of an economy in catching-up from a relatively backward sectoral specialisation to a relatively advanced one, and could thereby be applied to the study of the more “modern” version of the Kuznets’ curve, i.e. that referring to the impact of an SBTC (Kuznets II, see Section 1).
The model’s dynamics is driven by the following basic equations.
(2) (3)
(4)
(5)
Equation 2 describes the evolution of labour productivity in a generic sector i. It is based on the idea of localised technical change (see previous section), which makes technical knowledge a public good at the sectoral level but not at the economy wide level. In particular, technical change is path-dependent and based on a form of learning-by-doing process, which links productivity increases with the density of economic activity in a sector; hence, productivity growth rates are proportional to the share of capital invested in a sector. k denotes the capital share of investment in the skilled intensive technology. gi are parameters that characterise the productivity gains in the various sectors of the economy. A realistic assumption is that the skilled-intensive technology is able to guarantee higher productivity growth rates. Thereby, we assume that g1>g2.