Higher Education Levels, Firm's Outside Option and the Wage Structure

We analyze the consequences of an increase in the supply of highlyeducated workers on relative and real wages in a search model where wages are setby Nash bargaining. A key insight is that an increase in the average education levelexerts a negative externality on wages through its positive externality on the firms'outside option. As a consequence, the real wage of all workers decreases in theshort run. Since this decline is more pronounced for less educated workers, wageinequality increases. In the long-run a better educated work force induces firms toinvest more in physical capital. Wage inequality and real wages of highly educatedworkers increase while real wages of less educated workers may decrease. Theseresults are consistent with the US experience in the 1970s and 1980s. Based upondifferences in legal employment protection we also provide an explanation for thediverging evolution of real and relative wages in Continental Europe.