Saturday, July 15, 2006

Lazear vs Krugman

CEA Chair Eddie Lazear in May 2006:
While there is no doubt that some people have been left behind, and that those left behind are certainly a major concern for all of us, there is some good news in this picture. The good new is that most of the inequality reflects an increase in returns to “investing in skills” – workers completing more school, getting more training, and acquiring new capabilities.
NY Times columnist Paul Krugman yesterday:
There's a persistent myth, perpetuated by economists who should know better -- like Edward Lazear, the chairman of the president's Council of Economic Advisers -- that rising inequality in the United States is mainly a matter of a rising gap between those with a lot of education and those without.
I am not sure what other "economists who should know better" Krugman is referring to. Maybe Daron Acemoglu, MIT professor and winner of the John Bates Clark award. Daron wrote in the Journal of Economic Literature a few years back:

The recent consensus is that technical change favors more skilled workers, replaces tasks previously performed by the unskilled, and exacerbates inequality. This view is shaped largely by the experience of the past several decades, which witnessed both major changes in technology, including the rapid spread of computers in workplaces and in our lives, and a sharp increase in wage inequality. In the United States, for example, the college premium—the wages of college graduates relative to the wages of high-school graduates—increased by over 25 percent between 1979 and 1995.

My understanding is that there is a widespread consensus that the returns to education have risen substantially over the past few decades. But the education wage premium is not the whole story, as wage inequality within education categories has also increased substantially. Here is an attempt to explain the second piece of the puzzle, from Thomas Lemieux in the most recent issue of the American Economic Review:

This paper shows that a large fraction of the 1973-2003 growth in residual wage inequality is due to composition effects linked to the secular increase in experience and education, two factors associated with higher within-group wage dispersion. The level and growth in residual wage inequality are also overstated in the March Current Population Survey (CPS) because, unlike the May or Outgoing Rotation Group (ORG) CPS, it does not measure directly the hourly wages of workers paid by the hour. The magnitude and timing of the growth in residual wage inequality provide little evidence of a pervasive increase in the demand for skill due to skill-biased technological change.
That is, part of the increase in inequality is measurement error, and part of the increase is attributable to the fact that the labor force is older and more educated--characteristics that are associated with higher residual variance.

Update: A comment points out this relevant quotation:

The causes of this increase in equality [from 1979 to 2003] are a subject of some controversy, but probably the most important cause is rapid technological change, which has increased the demand for highly skilled or talented workers more rapidly than the demand for other workers.
Source: Microeconomics, by Paul Krugman and Robin Wells, page 512.

I suppose that Paul has changed his mind since this book (copyright 2005) was written. It is a bit harsh, however, for Paul to be so hard on Eddie for believing what Paul believed not very long ago.

Perhaps Paul would reconcile the apparent disparity here by drawing a distinction between acquired skills and inherent talent. Eddie suggests that the increased inequality is mostly from higher returns to acquired skills, and Paul may think it is more from increased returns to inherent talent. But that is just conjecture on my part.

Update 2: Brad DeLong tries to explain what Paul might have been thinking:
The big rise in inequality in the U.S. since 1980 has been overwhelmingly concentrated among the top 1% of income earners....It's hard to attribute this pattern to a rise in the premium salary earned by the well-educated by virtue of the skills their formal education taught them. Such a rise in the education premium would produce a much smoother rise in relative incomes among the whole top tenth of the income distribution.
I am not convinced that the conclusion follows from the facts presented. I would guess that the top 1 percent of income earners (those earning more than $276,945) are disproportionately very well educated--doctors, lawyers, MBAs, etc. So the rise in the income of the top 1 percent could well represent in large part a higher education premium.

What might well be true is that the returns to education have become increasingly non-linear: The most educated are now getting a bigger return from a marginal year of education than those with moderate amounts of education. In other words, two years getting an MBA from Harvard Business School may increase a person's income more in percentage terms than does two years getting an Associate Degree from Mass Bay Community College. My understanding from my labor economist friends is that some evidence favors this hypothesis of increasing nonlinearity.

To some extent, the returns to human capital are random (as is true of physical capital). Getting an MBA gives you a shot at being CEO, but it is not a guarantee. This may be part of the Lemieux finding that higher levels of education are associated with higher residual variance. And perhaps it can reconcile the differing perspectives of Krugman and Lazear.