Sectoral allocation of foreign capital inflows and skilled‐unskilled wage inequality in a developing economy: A theoretical model

We consider a small open developing economy using a 2 × 3 general equilibrium model with voluntary unemployment of skilled labor and involuntary unemployment of unskilled labor. It is assumed that there exists surplus unskilled labor in the developing economy and supply of skilled labor is a function of skilled wages. One sector is receiving foreign capital at the expense of another sector. We examined the impact of increasing total foreign capital inflows and sectoral allocation of foreign capital inflows on skilled‐unskilled wage inequality. Our findings suggest that wage inequality as well as employment of unskilled labor increases with increase in total foreign capital inflows, whereas wage inequality decreases with increase in foreign capital inflow into the low‐skilled sector with no change in total foreign capital inflows. Besides, it also indicates that the impact of increasing total foreign capital inflows along with changes in sectoral allocation of foreign capital inflows depends on a cutoff value which is a function of initial sectoral allocation of foreign capital into the two sectors. These results could be important for policymaking in the developing countries like India. Numerical examples have also been constructed to capture the extent of changes in wage inequality.