RDP 1999-12: Unemployment and Skills in Australia 2. International Evidence and Theory

Our first task is to define the meaning of skill. In theoretical models, the labour force is generally divided neatly into a ‘skilled’ group and an ‘unskilled’ group, where skilled labour characteristically has higher productivity than unskilled labour.^[2] Following in this vein, much empirical research has defined distinct skill groups according to measured worker characteristics likely to be correlated with a worker's marginal product, such as educational attainment, occupation or years of experience in the labour force.

An alternative approach, applied in Juhn, Murphy and Topel (1991), is to classify skill levels by an individual's position within the earnings distribution. Despite the conceptual appeal of such an approach, it has some drawbacks. The first is that many individuals are unemployed, and thus do not have any market income. (Juhn et al calculate an imputed skill level for these individuals by comparing their observed characteristics to workers at different points in the wage distribution.) Secondly, if employee remuneration is not competitively determined, but instead reflects the extraction of rents, then observed remuneration will not be an accurate reflection of marginal product, Thirdly, the Juhn et al approach provides a relative, rather than an absolute, measure of skill. It does not capture changes in the skill base of the workforce as a whole, such as an increase in the average level of education.

A third approach to measuring skill is to rank occupations according to the intensity of different abilities used, such as cognitive, interactive and motor skills (Pappas 1998). This approach highlights the fact that the ability set required for many ‘low-skilled’ occupations is substantially different from that required for ‘high-skilled’ jobs.

For the purposes of this paper, we refer to skills in a general sense as relatively higher levels of education, experience or inherent abilities that enhance an individual's productivity. Empirically, we use educational attainment and occupation to classify individuals according to skill level.

2.1 Unemployment and Skills Across the OECD

Figure 1 presents unemployment rates by educational attainment for a number of OECD countries, including Australia. Since the level of education used to distinguish skill groups differs across countries, it is not possible to make direct cross-country comparisons of the rates of skilled and unskilled unemployment. However, several facts are clear.

First, skilled and unskilled unemployment in each of these countries fluctuates in a relatively synchronised fashion. Changes in the unemployment rates for different skill groups are mainly determined in the short run by the state of the business cycle.

Second, the unskilled unemployment rate is much higher than the skilled rate within each country. This fact is true both for nations with highly deregulated labour markets (the United States) and nations with centralised, highly regulated markets (such as France). The only exception to the rule that the less educated have higher unemployment rates is Italy; however, this appears to reflect country-specific factors. Italy has a much less generous social security system than other OECD countries,^[3] and educational attainment is strongly correlated with parental income. Thus, young educated workers are often able to live off parental income while searching for a job, whilst less-educated individuals do not have such opportunities.

Third, the aggregate unemployment rate has increased substantially in most of the countries shown. This has been associated with an increase in unemployment for both low- and highly-educated workers. However, in each case the percentage point increase in unemployment has been greater for the less-educated group.

2.2 A Framework for Analysis

How can economic theory assist us in thinking about the evolution of skilled and unskilled unemployment? Nickell and Bell (1995) present a useful analytical framework suited to this purpose. In their model, the labour force is divided into a skilled and unskilled group, where the unemployment rate of each group is set by the interaction of a labour demand curve and a wage-setting curve. This wage-setting curve (alternatively referred to as an effective labour supply curve or supply-wage curve) represents a locus of employment and wage outcomes consistent with the wage-setting behaviour of employees and firms.^[4] The existence of involuntary unemployment stems from the role of unemployment in matching the wage demands of workers and the mark-up behaviour of firms.

The relative positions of skilled and unskilled labour are drawn on Figure 2 – the diagram is drawn so that unskilled unemployment is higher than skilled unemployment, consistent with current experience. Both the wage-setting and labour demand curves are higher for skilled workers, reflecting their higher productivity. This diagram is drawn with the employment ratio (employment/labour force), rather than employment, as the x-axis. Thus, the unemployment rate is measured by the horizontal distance between equilibrium and an employment ratio of 1. Matching increases in labour demand and supply will leave the labour demand curve as drawn unchanged, since employment and the labour force increase proportionately.

We use this framework to examine the effects of demand and supply shifts on the unemployment rate. Firstly, we review how the demand for skilled and unskilled labour has changed across the OECD in recent decades.

2.3 Demand Shifts

The most notable change in labour market conditions across skill groups in recent years has been a substantial increase in the demand for skilled labour. This has led to higher levels of skilled employment across the OECD, and in many countries a higher wage premium paid to skilled workers. Wages for low-skilled workers have not increased as quickly, and have actually fallen in real terms in some countries, particularly the United States. These trends follow in the wake of a long period during the 1950s and 1960s in which wage relativities between high- and low-income earners narrowed.

Two main explanations have been offered for this set of outcomes. The first of these is that increased trade competition from developing nations has, through factor price equalisation, reduced the wages of low-skilled workers in developed countries, and reduced the output of the industries which employ low-skilled workers intensively (see Wood (1995) for an exposition of this view). The current consensus is that this ‘trade’ argument explains only a small part of the increased demand for skill (Katz 1998).^[5]

The more widely accepted explanation is that technological progress has increased the productivity of skilled workers relative to unskilled workers, a phenomena dubbed ‘skill-biased technological change’ (SBTC). Following Griliches (1969), various authors have argued that skilled labour is a complement in production to capital and/or technology, and that the degree of complementarity is much higher than for unskilled labour.

Several pieces of evidence have been offered in favour of SBTC. Firstly, the increased demand for skilled workers is not simply the result of changes in industry mix, since the proportion of skilled workers has increased in all industries, in both traded and non-traded sectors, often in spite of a higher wage premium paid to skilled labour. Secondly, there are strong correlations between measures of technological progress and increased demand for skills. Autor, Katz and Krueger (1998) find correlations between increased demand for skilled workers across firms and measures of computerisation such as computer capital per worker, computer investment as a share of total investment and growth in employee computer usage.^[6] Thirdly, increased demand for skill appears to be a common feature of most developed countries' labour markets, and the same industries in different countries are increasing their proportion of skilled labour (Berman, Bound and Machin 1994). These trends are consistent with SBTC, since technological advances in one country would be expected to be readily transferable to other countries.

There is less evidence on SBTC for Australia than for some other countries. The available literature is reviewed in Borland (1998). Using data on relative wages, employment and labour supply, several authors have found that demand for Australian workers with higher levels of education has increased steadily since the 1970s. However, the relative extent to which trade, technology and other factors are responsible for this demand shift is still unresolved.

The effects of SBTC on the dispersion of wages and employment opportunities can be mitigated somewhat by improving education and training opportunities for the less skilled. Goldin and Katz (1998) propose this as an explanation for the contrasting evolution of the US wage structure from 1910 to 1940 compared with the past two decades, both periods where substantial SBTC was evident. In the earlier period, the increase in the return to skill was coincident with a massive expansion in secondary education, providing necessary skilled labour and containing wage relativities (which actually narrowed over this period). In the most recent period however, the expansion in education for the less skilled was not nearly as large and the returns to education increased substantially, as did wage inequality.

2.4 The Effect of Relative Demand Shifts on Unemployment

Although there is some agreement about the causes underlying the higher demand for skilled workers across the OECD, there is less consensus about the effect of this trend on unemployment. Krugman (1994) and Freeman (1995) (among others) have suggested the increased demand for skill has created a ‘diabolical trade-off’ between unemployment and income inequality. In countries where wages are flexible, such as the United States, increased returns to skill have resulted in increased wage and income inequality. In countries like France and Germany, institutional factors have helped maintain wage relativities, but at the cost of high unemployment for unskilled workers who have been priced out of the labour market.

This characterisation however, seems inconsistent with a number of empirical facts. First, the rise in European unemployment has occurred in all labour market groups, not just the unskilled. Second a number of European countries (such as Austria and Norway) with highly regulated labour markets and tight wage relativities enjoy unemployment as low or lower than the United States. Third, even in the United States, unemployment and non-employment is much higher for unskilled workers than for skilled workers; moreover, unskilled unemployment has increased relative to skilled unemployment since the 1970s (Juhn et al 1991).

We can use the Nickell and Bell (1995) model outlined previously to compare the effects of a negative aggregate labour demand shock (in which demand falls proportionately for skilled and unskilled labour) and a relative labour demand shock, (in which labour demand falls for unskilled workers, but rises for skilled workers). An example of the latter would be a technology shock that favoured skilled labour. Figure 3 shows the impact of both these types of shocks.

Following the aggregate shock, demand for skilled and unskilled labour shifts downwards proportionally, reducing wages and increasing unemployment for both groups. (An alternative shock that delivers the same outcome would be a proportional upward shift in the wage-setting curve for high-skilled and low-skilled workers.) Note that the absolute increase in the unemployment rate is higher for unskilled workers than for skilled workers, because unskilled workers are presumed to be operating on a flatter part of their wage-setting curve.

In the case of a relative demand shift towards skilled labour and away from unskilled labour, the unskilled unemployment rate increases, and skilled unemployment falls. Since the rise in unskilled unemployment is more pronounced, the aggregate unemployment rate also rises.

Using this framework, Nickell and Bell estimate that in Great Britain, a neutral shock causing an increase in skilled unemployment of x per cent (e.g. a 10 per cent rise, from 5 per cent to 5.5 per cent) will increase unskilled unemployment by 0.83 × x per cent (e.g. from 10 per cent to 10.83 per cent). They find that only around one-fifth of the rise in the aggregate unemployment rate in Britain between the mid 1970s and late 1980s is explained by a shift in demand against the less-skilled (equivalent to 1.1 percentage points of unemployment). The remainder (which explains a further increase in unemployment of 4.4 percentage points) is explained by adverse aggregate factors. In contrast to Nickell and Bell's findings for Britain, Juhn et al (1991) show using data from the Current Population Survey that unskilled unemployment and non-employment rates increased markedly in the United States over the 1970s and 1980s, whilst unemployment rates for skilled workers barely changed.^[7] They use these facts to argue that a relative demand shift against unskilled workers was responsible for an apparent increase in the natural rate of unemployment observed in the United States over this period. Differences in the rate of growth in the supply of skilled labour between Britain and the United States may help to reconcile the contrasting evolution of the unemployment structure in the two countries.

What has been assumed for Nickell and Bell's analysis? Firstly, the wage-setting curve must be flatter for unskilled workers than for skilled workers. Nickell and Bell use the following specification for the wage-setting curve:

W_i is the wage for the ith group, γ_i is a wage-setting parameter, u_i is the group's unemployment rate and X is an economy-wide labour productivity parameter.

This functional form is commonly used to model the real wage–unemployment nexus for several reasons. First, the double-log specification ensures that the unemployment rate at the bargained wage outcome cannot fall below zero, since the wage demands of workers increase rapidly as the unemployment rate falls to low values. Conversely, as unemployment rises the curve becomes flatter, as the market wage converges towards individuals' reservation wage. Second, this functional form arises naturally from several non-competitive theoretical models of the labour market, such as a Shapiro and Stiglitz (1984) efficiency wage framework, or a Layard, Nickell and Jackman (1991) markup model. Finally, Blanchflower and Oswald (1994) empirically test the specification in Equation (1) against a range of alternative functional forms, and generally find that the double-log specification provides the best fit to the data for a range of countries.

More controversially, Equation (1) also implies that the wage-setting curve of less-skilled workers depends on economy-wide productivity (X), rather than the productivity of the group. Consider a shock that increases skilled productivity but decreases unskilled productivity. Demand for unskilled workers shifts downwards, their wage-setting curve – which depends on economy-wide productivity – remains constant, and unskilled unemployment rises. However, if the wage-setting curve depends on the group's productivity, then a shift in demand away from unskilled labour has no effect on unemployment, it simply shifts the wage-setting curve downwards for these workers.

Nevertheless, this assumption of Nickell and Bell's does not seem responsible for their finding that only a small part of the rise in aggregate unemployment in Britain is a consequence of a relative demand shift against the unskilled. Jackman et al (1997) use a more general framework than Nickell and Bell, which allows for shifts in the wage-setting curves for skilled and unskilled workers in response to movements in relative productivity. They estimate the effect of relative demand shifts on unemployment in Britain to be only 0.5 percentage points.^[8] For a number of other countries, the effect of demand shifts on unemployment is even smaller. These results follow quite naturally from the stylised fact that for most countries considered by Jackman et al, skilled and unskilled unemployment rates rose almost proportionally during this period. In contrast, a relative demand shift against the unskilled should increase unskilled unemployment, but reduce skilled unemployment. As discussed earlier, Juhn et al (1991) provide some evidence that this did occur in the United States; however, it is not evident in most other countries.

In the Nickell and Bell framework, wage rigidity should exacerbate the differential employment effects of labour demand shifts. If the level of low-skilled wages cannot fall, they should experience an even larger decline in employment. However, Card, Kramarz and Lemieux (1998) present evidence that these forces are weak. They compare employment and wages in the United States, Canada and France. They find that although trends in wages dispersion were very different across the three nations, shifts in employment were quite similar. Nickell (1996) suggests a possible explanation for this surprising result. He presents evidence that the level of basic literacy and numeracy is much higher in continental Europe than in either Great Britain or the United States – the two countries generally singled out as having large falls in wages for the unskilled. Thus, ‘low-skilled’ workers in France were better able to cope with a fall in demand for unskilled labour because of their higher level of basic education, and also perhaps their greater opportunities to complete higher education. In this respect (though clearly not in aggregate unemployment outcomes), continental Europe has outperformed many flexible wage countries, in coping with a relative demand shift against the unskilled without engendering a massive fall in the relative wages of less-skilled workers.

Footnotes

Examples include Berman, Bound and Machin (1997) and Haskel and Slaughter (1998) from a trade perspective, and Nickell and Bell (1995) and Jackman et al (1997) from the labour economics literature. [2]

Martin (1998, p. 296) reports that the replacement ratio in Italy is the lowest of a sample of 18 OECD nations, by a substantial margin. For a family experiencing long-term unemployment, the Italian replacement ratio is only a quarter as large as the next lowest country (the United States). A similar situation (no substantial unemployment benefit system and a high unemployment rate for educated individuals) exists in India. [3]

The position of the wage-setting curve is affected by factors which influence the relative bargaining strength of insiders and outsiders, such as the degree of union power, generosity of welfare payments, and the level of long-term unemployment (see Layard, Nickell and Jackman (1991)). [4]

If the ‘trade’ explanation is dominant, we should expect a shift in employment towards skill-intensive industries and a reduction in the ratio of skilled to unskilled employment within each industry as a result of the fall in unskilled wages. These trends are not apparent in the empirical data for most countries (Krugman 1994). Slaughter and Swagel (1997) report that a number of different methodologies have been used to estimate the effect of increased trade and globalisation on wages and employment in the United States, and have generally found the effects to be only small. [5]

Although see DiNardo and Pischke (1997) for a skeptical view of this evidence. [6]

Juhn et al (1991) measure skill by position in the income distribution. Using an education-based measure of skill, the increase in the wedge between skilled and unskilled unemployment is less obvious, at least over the 1980s (Jackman et al 1997). [7]

Another difference between the two studies is that Layard et al (1991) use a different definition of a ‘neutral’ shock, one which requires that a relative demand shift towards the skilled must be matched by a corresponding relative demand shift away from the unskilled. For this reason also, their approach is somewhat more conceptually attractive than Nickell and Bell. [8]