Supply and Demand Factors in Understanding the Educational Earnings Differentials: West Germany and the United States

1. Introduction There is a vast literature that has documented the trends and differences in earnings inequality in the United States and the European countries. Widespread consensus indicates that the United States and the United Kingdom stood out from rest of the developed countries because of significant widening in their wage distributions during 1980s. There have been many studies that tried to explain the wage differentials across countries and some of those held institutional constraints responsible. They tried to show that those countries with slow growth in wage inequality were usually the ones with more centralized wage setting institutions. In this paper, we try to explain the earnings differentials of two countries, the United States and West Germany during 1980s and 1990s, by focusing on educational earnings differentials. Since the evolution of wages and inequality are substantially different in West and East Germany, we restrict our analysis to West Germany (Gernandt and Pfeiffer, 2007). Our goal is to understand the importance of institutional factors and the market forces in explaining the earnings differentials across the two countries in the 1980s and how they have changed in the following decade. An advantage of this pair wise comparison is less compromise on data quality compared to studies that analyze many countries. This study improves upon the existing literature by examining the trends in the 1990s and early 2000s which is a period shaped by major policy changes (i.e., trends towards decentralization in German labor markets). Further, it uses a different skill grouping to achieve better comparison between the two countries. Since the way skill groupings are formed might disguise the recent phenomenon of job polarization, we run an additional test to investigate whether our sample reproduces evidence that is consistent with the recent literature or not. The paper is organized as follows. The next section reviews the literature. Section 3 analyzes the trends in earnings inequality in both countries. Section 4 uses data from the March CPS files and the German Socio-Economic Panel (GSOEP) along with Cross National Equivalent Files (CNEF) and implements the relative demand and supply framework to investigate the sources of earnings differentials between the two countries. Section 5 provides evidence for a recent phenomenon in the labor markets; i. e. polarization of work in both countries. And the last section concludes. 2. Literature Review From the late 1960s to the beginning of 1980s, most of the OECD nations including the United States and West Germany experienced rapidly declining educational wage differentials. The primary reason underlying this common pattern among countries was the rapid increase in supply of college graduates despite the shifts in demand favoring highly educated workers. However, experience of the United States diverged from that of other OECD nations in the 1980s. Rapidly increasing educational attainment in most OECD countries muted changes in their wage structures. On the other hand, slower growth in the supply of highly educated workers in the United States, combined with shifts in relative demand favoring skilled workers, resulted in rising wage differentials by skill and, hence increasing overall inequality (Freeman and Katz, 1994). A survey by Levy and Murnane (1992) concluded that the shifts in demand and supply provide the major explanation for the wage dispersion between skill groups. Most of the developed nations operate in similar economic environment. They adopt similar technologies in their production processes that lead to comparable industry and occupation mixes. That's why, shifts in relative demand for skilled workers will not radically differ among these countries. Most economists argue that relative demand shifts occurred due to skill-biased technological change. In other words, a change in the production process led to increasing marginal product of skilled workers relative to the unskilled workers, which resulted in increased relative employment of highly educated workers in most sectors of the economy (Katz and Murphy 1992). …