Explaining Latin America’s Decreasing Skilled Wage Premium: Supply, Directed Technical Change, and Demand

Skilled wage premia in Latin American countries have continued declining, albeit more slowly and unevenly. Is the decline driven by demand or supply? This paper proposes a novel adaptation to the demand-supply decomposition framework by incorporating directed technical change (DTC), specifically supply-induced skill-biased technical change that acts to increase the wage premium. DTC counters the traditional substitution effect through which higher education wage attainment reduces the skill premium. Therefore, DTC makes adjusted inferred demand changes less skill biased than the standard framework’s traditional inferred demand changes. We apply the framework to ten Latin American countries over three periods, namely the length of the sample, the period between maximum wage premia and 2015, and since 2015. In our baseline results, DTC is quantitatively significant while the substitution effects remain important. Traditional demand shifts were skill biased over the length of the sample including since 2015 but our novel adjusted demand shifts were skill neutral. During the period between maximum premia and 2015, unadjusted demand shifts were skill-neutral and adjusted demand shifts favored unskilled workers. Equivalently, sizeable DTC effects imply wages would have fallen significantly faster in the absence of DTC. For an alternative elasticity of 1.25, DTC effects are smaller, supply effects are bigger, and adjustments to demand effects are smaller. For alternative supply measures, the results are relatively robust.