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

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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Paper provided by University of Western Ontario, Centre for Human Capital and Productivity (CHCP) in its series University of Western Ontario, Centre for Human Capital and Productivity (CHCP) Working Papers with number 20142.

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Date of creation: 2014
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Handle: RePEc:uwo:hcuwoc:20142
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Centre for Human Capital and Productivity (CHCP), Social Science Centre, University of Western Ontario, London, Ontario, Canada N6A 5C2

Phone: 519-661-2111 Ext.85244
Web page: http://economics.uwo.ca/research/research_papers/chcp_workingpapers.html

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Find related papers by 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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  1. Lance Lochner & Alexander Monge-Naranjo, 2015. "Student Loans and Repayment: Theory, Evidence and Policy," Working Papers 2015-006, Human Capital and Economic Opportunity Working Group.
  2. Michael Kaganovich & Xuejuan Su, 2015. "College Expansion and Curriculum Choice," CESifo Working Paper Series 5299, CESifo Group Munich.
  3. Manuel Arellano & Richard Blundell & Stéphane Bonhomme, 2015. "Earnings And Consumption Dynamics: A Nonlinear Panel Data Framework," Working Papers wp2015_1506, CEMFI.
  4. 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).
  5. Laura Turner & Aloysius Siow & Gueorgui Kambourov, 2014. "Relationship Skills in the Labor and Marriage Markets," 2014 Meeting Papers 155, Society for Economic Dynamics.
  6. 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.
  7. Arabage, Amanda Cappellazzo & Souza, André Portela Fernandes de, 2015. "Labor earnings dynamics in post-stabilization Brazil," Textos para discussão 390, Escola de Economia de São Paulo, Getulio Vargas Foundation (Brazil).
  8. 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.

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