Firms’ Heterogeneity in Capital/Labor Ratios and Wage Inequality

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 ...rms. I document the increasing variance of capital/labor ratios across ...rms in the US labor market using Compustat data. I also show that the increase in the variance of capital/labor ratios across ...rms is related to the increasing variance of wages. To explain these empirical regularities I adopt a search model where ...rms di¤er in their optimal composition of capital between equipment and structure. As the relative price of equipment falls over time the distribution of capital/labor ratios becomes more dispersed across ...rms. In a frictional labor market this force generates wage dispersion among identical workers. In the model the increase in wage inequality is due only to job changers as they are randomly matched to an increasingly wide variety of jobs (capital/labor ratio). This feature of the model is consistent with recent evidence that indicates that the bulk of the increase in wage inequality took place between plants rather than within plants. Simple estimation of the model indicates that the dispersion of capital/labor ratios can explain up to one half of the total increase in residual wage inequality.