Why Has Urban Inequality Increased?

The increase in wage inequality since 1980 in the United States has been more pronounced in larger cities, even after accounting for di¤erences in the composition of the workforce across locations. Using Census of Population and Census of Manufacturers data aggregated to the local labor market level, this paper examines the importance of changes in the factor bias of agglomeration economies, capital-skill complementarity, changes in the relative supply of skilled labor, and mutual interactions for understanding the more rapid increases in wage inequality in larger cities between 1980 and 2007. Production function estimates that incorporate each of these mechanisms and factor biased technical change indicate strong evidence of capital-skill complementarity, increasing skill bias of agglomeration economies, declining capital bias of agglomeration economies and skill-biased technical change. Immigration shocks serve as a source of exogenous variation across metropolitan areas in changes to the relative supply of skilled versus unskilled labor. Holding factor quantities constant, changes in the factor biases of agglomeration economies rationalize at least 70 percent of the more rapid increases in wage inequality in more populous local labor markets absent capital-skill complementarity. Holding the factor bias of agglomeration economies constant, more rapid increases in the capital-skill ratio in larger cities, itself driven by relative skilled labor supply shifts and skill-biased technical change, have driven a similar fraction of these increases given capital-skill complementarity. However, the interaction between capital-skill complementarity and changes in the factor bias of agglomeration economies have generated inward shifts in the relative demand for skilled labor in larger cities that are su¢ ciently large to approximately o¤set one of the two other components. We thank Edward Glaeser, Kurt Schmidheiny and numerous seminar and conference participants for valuable comments. Camilo Andres Acosta Mejia and Adrian Rubli provided excellent research assistance.