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Understanding Earnings Dynamics: Identifying and Estimating the Changing Roles of Unobserved Ability, Permanent and Transitory Shocks

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Abstract

We consider a general framework to study the evolution of wage and earnings residuals that incorporates features highlighted by two inf uential but distinct literatures in economics: (i) unobserved skills with changing non-linear pricing functions and (ii) idiosyncratic shocks with both permanent and transitory components. We first provide nonparametric identification conditions for the distribution of unobserved skills, all unobserved skill pricing functions, and (nearly) all distributions for both permanent and transitory shocks. We then discuss identification and estimation using a moment-based approach, restricting unobserved skill pricing functions to be polynomial functions. Using data on log earnings for men ages 30-59 in the PSID, we estimate the evolution of unobserved skill pricing functions and the distributions of unobserved skills, transitory, and permanent shocks from 1970 to 2008. We highlight five main findings: (i) The returns to unobserved skill rose over the 1970s and early 1980s, fell over the late 1980s and early 1990s, and then remained quite stable through the end of our sample period. Since the mid-1990s, we observe some evidence of polarization: the returns to unobserved skill declined at the bottom of the distribution while they remained relatively constant over the top half. (ii) The variance of unobserved skill changed very little across most cohorts in our sample (those born between 1925 and 1955). (iii) The variance of transitory shocks jumped up considerably in the early 1980s but shows little long-run trend otherwise over the more than thirty year period we study. (iv) The variance of permanent shocks declined very slightly over the 1970s, then rose systematically through the end of our sample by 15 to 20 log points. The increase in this variance over the 1980s and 1990s was strongest for workers with low unobserved ability. (v) In most years, the distribution of unobserved skill pricing functions is positively skewed, while the distributions of permanent and (especially) transitory shocks are negatively skewed.

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  • Lance Lochner & Youngki Shin, 2014. "Understanding Earnings Dynamics: Identifying and Estimating the Changing Roles of Unobserved Ability, Permanent and Transitory Shocks," University of Western Ontario, Centre for Human Capital and Productivity (CHCP) Working Papers 20142, University of Western Ontario, Centre for Human Capital and Productivity (CHCP).
  • Handle: RePEc:uwo:hcuwoc:20142
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    1. Bartelsman, Eric & Dobbelaere, Sabien & Peters, Bettina, 2013. "Allocation of Human Capital and Innovation at the Frontier: Firm-Level Evidence on Germany and the Netherlands," IZA Discussion Papers 7540, Institute for the Study of Labor (IZA).
    2. Salvador Navarro & Jin Zhou, 2017. "Identifying Agent's Information Sets: an Application to a Lifecycle Model of Schooling, Consumption, and Labor Supply," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 25, pages 58-92, April.
    3. Lochner, Lance & Monge-Naranjo, Alexander, 2014. "Student Loans and Repayment: Theory, Evidence and Policy," Working Papers 2014-40, Federal Reserve Bank of St. Louis, revised 12 Nov 2014.
    4. Manuel Arellano & Richard Blundell & Stéphane Bonhomme, 2017. "Earnings and Consumption Dynamics: A Nonlinear Panel Data Framework," Econometrica, Econometric Society, vol. 85, pages 693-734, May.
    5. Guido Matías Cortés & Manuel Hidalgo-Pérez, 2015. "Changes in the Return to Skills and the Variance of Unobserved Ability," Working Papers 15.15, Universidad Pablo de Olavide, Department of Economics.
    6. Su, Xuejuan & Kaganovich, Michael, 2012. "College Expansion and Curriculum Choice," Working Papers 2012-25, University of Alberta, Department of Economics, revised 01 Apr 2015.
    7. Papageorge, Nicholas W. & Thom, Kevin, 2016. "Genes, Education, and Labor Market Outcomes: Evidence from the Health and Retirement Study," IZA Discussion Papers 10200, Institute for the Study of Labor (IZA).
    8. Arabage, Amanda Cappellazzo & Souza, André Portela Fernandes de, 2015. "Labor earnings dynamics in post-stabilization Brazil," Textos para discussão 390, FGV/EESP - Escola de Economia de São Paulo, Getulio Vargas Foundation (Brazil).
    9. Lance Lochner & Youngmin Park & Youngki Shin, 2017. "Wage Dynamics and Returns to Unobserved Skill," Staff Working Papers 17-61, Bank of Canada.
    10. Youngmin Park & Youngki Shin & Lance Lochner, 2017. "Earnings Dynamics and Returns to Skills," 2017 Meeting Papers 166, Society for Economic Dynamics.
    11. Mirko Felchner, 2015. "Einkommensdynamik bei Selbständigen als Freie Berufe und abhängig Beschäftigte Eine dynamische Paneldatenschätzung mit Daten des Sozio-oekonomischen Panels," FFB-Discussionpaper 101, Research Institute on Professions (Forschungsinstitut Freie Berufe (FFB)), LEUPHANA University Lüneburg.
    12. Laura Turner & Aloysius Siow & Gueorgui Kambourov, 2014. "Relationship Skills in the Labor and Marriage Markets," 2014 Meeting Papers 155, Society for Economic Dynamics.
    13. Michael Kaganovich & Xuejuan Su, 2016. "College Curriculum, Diverging Selectivity, and Enrollment Expansion," CESifo Working Paper Series 6122, CESifo Group Munich.
    14. Juan Sanchez & Alexander Monge-Naranjo & Lance Lochner, 2016. "Designing Efficient Student Loan Programs in the U.S," 2016 Meeting Papers 343, Society for Economic Dynamics.

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    JEL classification:

    • C14 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Semiparametric and Nonparametric Methods: General
    • C23 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Models with Panel Data; Spatio-temporal Models
    • J31 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Wage Level and Structure; Wage Differentials

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