Skill premium divergence: The roles of trade, capital and demographics

We construct an applied general equilibrium model to account for diverging patterns of the skill premium. Our framework assesses the roles of various factors that affect the demand and supply of skilled and unskilled labor—shifts in the skill composition of the labor supply, changes in the terms of trade and the complementarity between skilled labor and equipment capital in production. We find that increases in relative skilled labor supply due to demographic changes lead to a decline in the skill premium, while equipment capital deepening raises the relative demand for skilled labor, which in turn increases the skill premium. In addition, terms of trade changes lead to the reallocation of resources toward sectors in which countries enjoy comparative advantages. Since our model incorporates multiple factors simultaneously, it can generate either rising or falling skill premium paths. When we parametrize the model to the Baltic states—countries that were similar along many dimensions at the onset of their transition from centrally planned to market-oriented economies—our model can closely account for the diverging patterns of skill premia observed in the Baltics between 1995 and 2008.