Product Demand Shifts and Wage Inequality

The UK and the US have experienced both rising skill premia and rising employment of skilled workers since the 1980s. These trends are typically interpreted as concurrent shifts of relative skill supplies and demands, and the demand shifts are attributed to skill biased technological change or changes in international trade patterns. If more skilled workers demand more skill intensive goods, then an exogenous increase in relative skill supplies will also induce a shift in relative demand. This channel reduces the need to rely on technology and trade to explain the patterns in the data. In this paper, I illustrate this mechanism in a simple two-sector general equilibrium model. The empirical part of the paper demonstrates that more educated and richer workers indeed demand more skill intensive goods in the UK. Calibration of the model suggests that this induced demand shift can explain 12% of the total relative demand shift in the UK between 1981 and 1993. The baseline model only explains between industry shifts in skill upgrading and wage inequality, while empirically, most of these changes took place within industries. An extension of the model with different qualities of goods and labor is also able to explain some of the within industry changes.