AbstractIn recent years, there was a huge increase in the demand for skill in China as the economy developed rapidly; but the wages of young college graduates declined in real terms. Alarmed by the seeming over-supply of the young graduates, the Chinese government is considering policy measures to limit the growth of higher education. This phenomenon can be explained by a fully rational model in which the labor market evolves after the arrival of a large number of foreign (high- productivity) firms. High-productivity forms expand the demand for skill, which requires both education and experience, and induce a large increase of supply of college graduates. Although the returns to education rise, the wages of young college graduates may decrease if the supply of education is elastic. In the short run, there is an over-supply of young college graduate, and initial wage inequality exceeds that of the long run. Using a unique dataset, I find that these predictions are consistent with the development of the labor market in China. Moreover, supporting evidence for the theory from other rapidly developing countries is also discussed. Lastly, from a policy perspective, the model implies that there are adverse consequences of limiting the growth of college education during the transition, contrary to some current views in China.