Endogenous Economic Institutions, Wage Inequality, and Economic Growth

The proportion of college graduates in the United States labor force increased steadily after 1970. On the other hand, skill premium decreased during the 1970s but it increased during the 1980s and the 1990s. The law of demand and supply explains the decrease in the skill premium during the 1970s. Why did skill premium increase during the 1980s and the 1990s? This paper develops a novel economic growth theory, in which the level of education affects economic outcomes through economic institutions and policies. The model suggests that the increase in the proportion of college graduates in the United States labor force in the 1970s may have been a causal factor in both the decline in the college premium during the 1970s and the large increase during the 1980s and the 1990s. I argue that the proportion of skilled workers in the labor force determines their relative importance in the political process. Thus, the increase in the proportion of skilled workers during the 1970s reduced skill premium in the short run, but induced a change in policies that increased the skill premium in the subsequent decades above its initial value.