Firm Sorting and Spatial Inequality

We study the importance of spatial firm sorting for inequality both between and within local labor markets. We develop a novel model of spatial firm sorting, in which heterogeneous firms first choose a location and then hire workers in a frictional local labor market. Firms’ location choices are guided by a fundamental trade-off: Operating in productive locations increases output per worker, but sharing a labor market with other productive firms makes it hard to poach and retain workers, and hence limits firm size. We provide conditions under which there is positive firm sorting, with more productive firms settling in more productive locations. We show that positive firm sorting increases both the mean and the dispersion of wages in productive markets relative to less productive ones. The main mechanism is that firm sorting steepens the job ladder in productive places. We estimate our model using administrative data from Germany and identify firm sorting from a novel fact: Average local labor shares are lower in productive locations, which indicates a higher concentration of top firms with strong monopsony power. We infer that there is positive sorting of firms across space. Quantitatively, firm sorting can account for at least 16% of the spatial variation in mean wages and at least 38% of the variation in within-location wage dispersion.