The Rise of the Machines: Automation, Horizontal Innovation and Income Inequality

Abstract

We construct an endogenous growth model with automation and horizontal innovation in an economy with low- and high-skill workers. Automation enables the replacement of low-skill workers with machines, increasing the skill premium and possibly decreasing low-skill wages. Horizontal innovation increases both wages. Higher low-skill wages increase incentives to automate so that automation plays a bigger role as an economy develops. Our model is consistent with a permanently increasing skill premium, a temporary drop in low-skill wages and a drop in the labor share. We calibrate it and show that taxing automation innovation reduces low-skill wages in the long run.

Keywords: Capital-skill complementarity, income inequality, automation, horizontal innovation, wage polarization

JEL Classification: E23, E25, O31, O33, O41