1.1 The Empirical Puzzle

Contemporary labor market dynamics present a significant challenge to standard economic models. Over the past half-century, advanced economies have witnessed a dramatic increase in the relative supply of skilled workers, driven largely by expansions in higher education. Standard theory predicts this would depress the relative wages of skilled labor. However, the data show the opposite: the skill premium has risen sharply, particularly since the 1980s. This empirical fact, clearly depicted in Figure 15.1, implies the existence of a powerful, non-neutral force that has systematically shifted labor demand in favor of skilled workers, overwhelming the countervailing effect of their expanding supply.

1.2 The Limits of Exogenous Growth Models

Traditional neoclassical growth theories, such as the Solow model (Chapter 2), are ill-equipped to explain this phenomenon. Their central limitation lies in treating technological progress as an exogenous process—effectively a “black box”—that is neither explained by nor responsive to economic incentives within the model. By assuming the character of technological progress is given, or at best constrained to be purely labor-augmenting to ensure a balanced growth path, these models cannot explain why technology might become systematically biased towards certain factors of production in response to changing economic conditions.

1.3 Core Objective

The primary objective of this research is to develop and analyze a model of directed technological change to formally investigate how capital accumulation and factor substitutability endogenously determine the bias of innovation. The central goal is to provide a coherent theoretical explanation for the observed concurrent rise in the relative supply of skills and the skill premium. By extending the canonical framework to a three-factor environment (skilled labor, unskilled labor, and physical capital), this project will offer a more complete picture of the forces shaping income distribution in modern economies.