A central puzzle in modern labor economics challenges a fundamental tenet of standard economic theory. Basic supply and demand models predict that an increase in the supply of a factor of production should, all else being equal, lead to a decrease in its relative price. Yet, over the last several decades in the United States and other advanced economies, both the relative supply of skilled labor and its relative wage—the skill premium—have increased concurrently. The empirical evidence motivating this research, particularly the trend documented in Figure 15.1 of Acemoglu’s text, starkly illustrates this departure from simple theoretical predictions. This simultaneous rise suggests that the relative demand for skilled labor must have increased even more rapidly than its supply, prompting a critical question: what economic forces are driving this sustained shift in labor demand?

The core objective of this proposal is to outline a research program investigating the theory of directed technological change as the most promising and powerful framework for resolving this puzzle. This theory posits that the direction of innovation is not random but is endogenously determined by profit incentives, which are themselves shaped by relative factor supplies. By treating the bias of technology as an outcome of economic decisions, this framework can explain how a rising supply of skilled labor can trigger the very innovations that increase the relative demand for it.

This research will focus specifically on how the process of capital accumulation and the elasticity of substitution between capital, skilled, and unskilled labor interact to determine the long-run bias of innovation and, consequently, the trajectory of income inequality. By moving beyond the canonical two-factor models, this work aims to provide a richer, more complete understanding of the deep relationship between factor endowments and the nature of technological progress.