Abstract
This paper uses data from the March Current Population Survey and German Socio-Economic Panel to investigate the role of market forces and the institutional constraints in explaining the educational earnings differentials in the United States and West Germany. We make use of simple supply and demand framework to differentiate the effects of market forces from wage-setting institutions. Results indicate that differential growth in the relative employment of skilled workers is responsible for the differences in returns to skill in both countries over the period of analysis. In particular, rising educational attainment is the major factor underlying the changes in the employment of skilled workers in each country and it is followed by institutional factors. However, in addition to the differential growth in relative demand for skilled labor, differences in wage-setting institutions explain most of the cross-country differences in skill premia. We also provide evidence for polarization of jobs which is a recent phenomenon in both labor markets.