Inside the Agglomeration Black Box: Sorting, Matching or Learning?

Abstract:

Why do workers earn higher wages in larger cities, and why does the city-size wage gap increase over the life-cycle? In this paper, I address this long-standing questions by building a structural model that I use to measure the contribution of sorting, returns to scale in the labor search process, and knowledge spillovers within cities. The model is estimated so as to replicate key features of the heterogeneity in workers' labor market experience across small and large cities. I validate the estimated model by testing its ability to generate migration choices that are consistent with some untargeted moments related to the selection into and the return to migration. A decomposition of the city-size wage gap shows that both sorting of high-skilled workers and knowledge spillovers become increasingly important over the life-cycle, each accounting for about 40% of the gap after 20 years of labor market experience - the remaining portion is generated by higher firm-worker match quality due to increasing returns to search. I then use this framework to study the aggregate and distributional consequences of changes in the house price elasticity to city-size (for example, due to housing regulation). The benefit of lower living costs in a large city is counteracted by the deterioration in its worker composition, which limits its role as a place of knowledge diffusion.