The Elasticity of Substitution Between Skilled and Unskilled Labor in Developing Countries: A Directed Technical Change Perspective

IMF Working Papers, August 11, 2023

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Canonical URL: The Elasticity of Substitution Between Skilled and Unskilled Labor in Developing Countries: A Directed Technical Change Perspective

Author: Alberto Behar
Date: August 11, 2023
Type: IMF Working Paper No. 2023/165
Core contribution: Develops a model of endogenous skill-biased technical change in developing countries and produces new empirical estimates of the elasticity of substitution between more- and less-educated workers.

The model shows that the endogenous response to a rise in skill supply counters the traditional substitution effect and dampens its role in reducing wage inequality.
The model reconciles dispersed existing estimates and re-enforces consensus estimates of the elasticity of substitution between more/less educated workers.
The model rationalizes estimates that were previously deemed implausible or model-inconsistent.
New empirical estimates:
- Using a novel global panel, the elasticity of substitution is found at or just above 2.
- Using Latin American data that facilitates analysis of dynamics, estimates are reduced to 1.7-1.8.

The paper develops a theoretical model of endogenous skill-biased technical change tailored to developing country contexts.
Empirical strategy includes:
- A novel global panel covering developing countries (details in the paper).
- A Latin American dataset enabling dynamic analysis, which yields lower elasticity estimates (1.7-1.8).

The elasticity of substitution parameter is crucial for understanding:
- Wage inequality and the skill premium.
- Growth accounting and broader macroeconomic dynamics in developing countries.
Key implication: Endogenous directed technical change mitigates the mechanical effect of rising skill supply on reducing wage inequality, altering how policy and projections should interpret changes in skill composition.