Abstract : We analyze the consequences of an increase in the supply of highly
educated workers on relative and real wages in a search model where wages are set
by Nash bargaining. A key insight is that an increase in the average education level
exerts 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 the
short run. Since this decline is more pronounced for less educated workers, wage
inequality increases. In the long-run a better educated work force induces firms to
invest more in physical capital. Wage inequality and real wages of highly educated
workers increase while real wages of less educated workers may decrease. These
results are consistent with the US experience in the 1970s and 1980s. Based upon
differences in legal employment protection we also provide an explanation for the
diverging evolution of real and relative wages in Continental Europe.