published in: Economic Journal, 2007, 117 (518), 375-398
This paper provides some empirical evidence and a theory of the relationship between
residual wage inequality and the increasing dispersion of capital/labor ratios across firms. I
document the increasing variance of capital/labor ratios across firms in the US labor market. I
also show that the increase in the capital intensity variance across firms is associated with
the increasing wage variance across workers. To explain this empirical fact, I adopt a search
model where firms differ in their optimal capital investment. The decline in the relative price of
equipment capital makes the firm distribution of capital/labor ratios more dispersed. In a
frictional labor market, this force generates wage dispersion among identical workers. Simple
calibration of the model indicates that the dispersion of capital/labor ratios can account for
about one third of the total increase in residual wage inequality.
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