Why does skill intensity vary across cities? The role of housing cost

•Economic theory predicts that skill intensity of a city rises with house prices.•Using panel data and instrumenting house prices this hypothesis is tested.•Find that house prices play a dominant role in explaining city skill intensity.•Results are robust both in sign and size of the house price effect.•Implies that housing cost be included in explanations of skill intensity of cities.

The ratio of skilled (college graduate) to unskilled (non-college graduate) workers (the skill intensity ratio, SIR) varies substantially across cities and the variance in the SIR has increased significantly since 1970. Recent research finds that the ratio of skilled to unskilled worker earnings (the skilled wage ratio, SWR) also varies significantly. The “income elasticity hypothesis” (IEH) holds that if, as empirical evidence suggests, the income elasticity of demand for housing is significantly below unity, then the SWR should vary inversely with house prices. This implication of the IEH has been confirmed in empirical tests and leads to a further consequence of the IEH. If the SWR varies inversely with house prices, the SIR should vary directly as employers substitute more skilled workers when the SWR falls. This provides the opportunity for a new test of the IEH which is conducted here. The results strongly confirm, consistent with the IEH, that housing cost is an important determinant of variation in the SIR across cities.