Skill Formation, Capital Adjustment Cost and Wage Inequality*

Abstract: The paper employs a three-sector general equilibrium model for examining the consequences of an infrastructure development scheme to the education sector and an inflow of foreign capital on the skilled-unskilled wage inequality in a developing economy. The education sector faces a capital adjustment cost for which the effective unit cost of capital depends positively on the amount of capital employed. Although both infrastructure development scheme and inflows of foreign capital lead to higher skill formation, the policies produce incongruent effects on the wages of skilled and unskilled labour. Furthermore, the effects of the policies on the skilled-unskilled wage inequality depend crucially on the relative factor intensities of the low-skill and high-skill sectors. Finally, which of the two policies should the country adopt depends on the technological, institutional and trade related factors