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On the geography of inequality: labour sorting in

general equilibrium

Santiago Truffa & Alexis Montecinos

To cite this article: Santiago Truffa & Alexis Montecinos (2024) On the geography of inequality:
labour sorting in general equilibrium, Spatial Economic Analysis, 19:3, 324-344, DOI:
10.1080/17421772.2023.2271519

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SPATIAL ECONOMIC ANALYSIS
2024, VOL. 19, NO. 3, 324–344
[Link]

On the geography of inequality: labour sorting in

general equilibrium
Santiago Truffaa and Alexis Montecinosb,c

ABSTRACT
We study how cities’ amenities and limited housing supply contribute to aggregate wage inequality and
affect housing prices through the sorting of heterogeneous skilled workers. We develop a general
equilibrium model where workers differ along a continuum of skills and compete for limited housing.
Our analysis suggests that spatial sorting accounts for 7.5% of the aggregate wage dispersion, increases
average housing prices by 20–40% in constrained cities, and makes the economy 1.9% more productive.
In addition, we evaluate a place-based policy that aims to expand the supply of houses in 1% of
constrained cities and find that it improves aggregate productivity between 0.2% and 0.4%. However,
the place-based policy has the unintended consequence of aggravating aggregate wage inequality by
the same magnitude.
KEYWORDS
labour sorting, inequality, housing, place-based policies

JEL D44, D58, F16, J24, R13

HISTORY Received 9 August 2022; in revised form 12 September 2023

1. INTRODUCTION

Rising wage inequality has been a defining feature of the US economy over the last few decades.
This increase in inequality has been accompanied by changes in the organisation of the economic
activity of cities. This reorganisation has generated severe urban differentiation: cities that con-
centrate a higher fraction of high-skilled workers also feature higher wages and housing prices.
Changes between cities have gone hand in hand with changes within cities, as more productive
places have also become more unequal.
While prior studies have shown the importance of physical characteristics of cities to the
spatial variation in wages and housing prices, it is still unclear how the heterogeneity in the labour
market affects the distribution of workers across and within cities, ultimately impacting wage
inequality and housing prices.1 This paper sheds light on this topic by developing a general equi-
librium model with a continuum of workers with different skills in multiple cities that compete
with each other for limited housing. The housing market is modelled as an auction where
workers with different skill sets engage in bidding wars. Cities with high amenities, labelled as
superstar cities, attract more high-skilled workers that outbid the average-skilled worker in the
housing market. As a result, there is a high concentration of high-skilled workers in high

CONTACT Santiago Truffa [Link]@[Link]

a
ESE Business School, Universidad de los Andes, Santiago, Chile
b
Sawyer Business School, Suffolk University, Boston, MA, USA
c
Universidad Adolfo Ibáñez, Business School, Santiago, Chile
Supplemental data for this article can be accessed online at [Link]

© 2023 Regional Studies Association

 On the geography of inequality: labour sorting in general equilibrium 325

amenities cities, which ultimately boost its productivity at the cost of a higher level of wage
inequality and higher housing prices. The average-skilled worker is shifted to cities with lower
amenities level, labelled as non-superstar cities and, due to their lower productivity, damped
the output of these areas. As a result, our model is able to replicate the ‘U’-shape distribution
of workers in superstar cities and the inverted ‘U’-shape of non-superstar cities.
Our modelling choice presents an advantage relative to the existing models in the literature
that impose a zero-profit clearing condition on the housing market, which forces the housing
supply to adjust to the point of zero rents. By modelling the housing market as an auction,
high-paid workers can outbid low-paid workers, which generates the realistic outcome of positive
rents. In addition, the heterogeneity of workers’ distributions across cities generates a rich cross-
sectional variation in house prices. Roback (1982) and Gyourko and Tracy (1991) attribute
differences in housing prices across cities mainly to variation in interurban amenities and
other local traits, such as intercity fiscal differentials. In our model, the interurban amenities
are a key component determining the intensity of which workers outbid each other in the housing
markets, resulting in a large concentration of high-skilled workers in cities with high amenities.
Other studies argue that those price differentials can mainly be explained by limited housing
supply in large metropolitan areas, such as New York, Los Angeles and San Francisco. These
superstar cities attract high-income families, shifting the income distribution and raising the
price of land. According to Gyourko et al. (2013), metropolitan statistical areas (MSAs) with
low land availability tend to be more productive due to the sorting of high-skilled workers
into these places. These same cities have been among the least likely to add new housing in
the last couple of decades, contributing to the exacerbation of regional divergences. Our
model displays a similar feature since the bidding wars on the limited housing supply pushes
housing rents up, which drives low-skilled workers who cannot afford those rents out of the
city limits. By establishing a link between city amenities, limited housing supply, and the sorting
of workers with a continuum of skills, we can study how city fundamentals contribute to wage
inequality, housing prices, and output growth through the spatial distribution of the population.
To the best of our knowledge, this is the first general equilibrium model to jointly
analyse the impact of amenities and limited housing supply on wage dispersion, house prices,
and growth when there is a continuum of workers with a different set of skills. This new frame-
work allows us to look deeper into within city dispersion and how it interacts with between city
dispersion.
The main findings are as follows. First, if workers account for both cities’ amenities and lim-
ited housing supply when deciding to relocate, spatial sorting makes the aggregate economy (i.e.,
taking into consideration superstar and non-superstar cities) 1.9% more productive. If we restrict
our analysis to places featuring a tighter housing market such as superstar cities, the average
increase in productivity is 30%. The rationale behind this result is straightforward: when we
allow for spatial sorting, most productive workers tend to cluster in large cities that require
more talent for technology-intensive tasks. As a result of the interaction between the sorting
of high-skill workers into big cities and the agglomeration externalities, workers’ marginal
productivity increases, contributing to the higher overall productivity of the economy.
Second, the influx of high-skill workers to large cities with limited housing supply puts
further pressure on the demand for housing and ultimately raises their price. Our model estimates
an average increase of 20–40% because of talent sorting in these metro areas. We show that this
effect is particularly detrimental to house prices in smaller cities, where housing supply is not con-
strained and can experience a decline by up to 30% due to the drain of talented workers.
Third, we show that spatial sorting has critical consequences for wage inequality when cities’
amenities and shortage of housing impact workers’ mobility decisions. We find that spatial sort-
ing accounts for 7.5% of the aggregate wage dispersion, and wage inequality is between 20% and
40% higher in those cities with tighter housing markets.

SPATIAL ECONOMIC ANALYSIS

326 Santiago Truffa and Alexis Montecinos

The reasoning goes as follows. Workers care, by assumption, about their disposable income
(i.e., wages net of housing costs) and amenities provided by the city they live in. Since
high-skilled workers have higher disposable income, they become more sensitive to the cities’
amenities. As they cluster in MSAs due to the high demand for high-skill tasks, they outbid
the low-skilled in the housing market and drive them out of the metropolitan area, which raises
the average salary within the city. As a result, wage dispersion within the city increases. In
addition, in equilibrium, those low-skilled workers who stay in superstar cities are compensated
with higher salaries as well since the supply of those workers diminishes significantly. Our model
shows that this mechanism can generate a differential of 30–50% in the salaries of the workers in
the 20th percentile of the skill distribution who live in large MSAs and those in the same group
living in smaller cities.
The fourth contribution of our study is to analyse how a place-based policy could potentially
ameliorate or aggravate inequality in large urban areas. We argue that our model is particularly
suitable for such a task because our framework is quantitatively tractable and rich enough to repli-
cate patterns in the dispersion of talent and wages of the Current Population Survey (CPS) for 54
MSAs in the US for 2011. It features the existence of a unique equilibrium, which allows us to
numerically quantify the equilibrium effects of place-based policies. Thus, by simply turning
spatial sorting off and reevaluating the model, we obtain a clear measurement of the impact of
sorting effects on equilibrium quantities. In particular, we focus on a housing policy aimed to
expand the housing supply in constrained cities by 1%. We find that such a policy could make
the economy 0.2–0.4% more productive. However, we show that relaxing housing constraints
in superstar cities has the unintended consequence of increasing aggregate wage inequality by
the same magnitude.
This result adds to the spatial literature by quantitatively assessing the effects of policies on
wage inequality. This topic has attracted the increasing attention of researchers in recent years.
Fajgelbaum and Gaubert (2020) argues that spillover generated by the concentration of economic
activity may lead to inefficient spatial outcomes, culminating in substantial welfare costs. The
authors show that increasing income redistribution toward low-wage cities through higher labour
income taxes in high-wage cities can restore efficiency. The idea is that these transfers incentivise
workers to move from high- to low-wage cities, resulting in an increase in the share of high-skill
workers in small cities and a reduction of wage inequality. Farrokhi and Jinkins (2019) shows that
the skill wage premium is smaller in geographically isolated cities because the higher cost of
tradeable in these cities makes them less appealing to high-skill workers that are less productive
in these regions. The authors find that 16.5% of the observed variations in the skill wage
premium is due to geographic location. Giannone (2019) shows that the interaction between
technology and local agglomeration is key to explain why the convergence of the wage gap of
high-skill workers between poorer and richer US cities declined after 1980.
Regional inequality is a complex topic and one that for several reasons requires general equi-
librium reasoning. First, in spatial equilibrium, workers must not prefer other locations to their
current ones. This indifference condition implies that population, wages, and housing prices in
all cities should be considered simultaneously, making them interdependent. Second, wages and
housing prices are inseparable from local agglomeration externalities and the distribution of skills
available in the city (Acemoglu & Dell, 2010; Combes et al., 2008; Gennaioli et al., 2013; Van
Nieuwerburgh & Weill, 2010). Investigating this association requires a model in which the
labour productivity of each worker is endogenous to the location decisions of all workers.
Third, to understand how city characteristics relate to regional inequality, we must disentangle
how they affect agglomeration externalities and skill sorting separately. The reason is that a
change in city characteristics (e.g., increasing the housing supply) could have an impact on
local labour productivity by increasing density and by changing the skill composition of the city.

SPATIAL ECONOMIC ANALYSIS

 On the geography of inequality: labour sorting in general equilibrium 327

The calibrated model is consistent with several stylised facts. For instance, the model features
the sorting of high-skilled workers into land-constrained cities. Given the higher supply of
skilled workers, these cities specialise in high-productivity sectors, generating an endogenous
correlation between low land availability and city productivity. Concurrently, land constrained
cities have the property of having higher wage inequality driven by the interaction of endogenous
relative prices and local agglomeration externalities. Furthermore, the calibrated model does a
reasonable job of predicting moments that had not been targeted in the estimation, such as rela-
tive average house prices and city size.
Since the model generate wages at the worker level, it means that we are able to look at both
within-city wage inequality and between-city wage inequality. This is a type of decomposition
that general models do not provide. In particular the model fleshes out a linear (and positive)
relation between average wages at the city level and wage dispersion at the city level, that
resembles what we observe in the data.
Regarding welfare, the model seems to be more limited to generate sensible predictions. This
is so, since the spatial equilibrium stem from imposing that (conditional on your type), utility its
equalised across space. Therefore, there is little to say about between cities and within cities wel-
fare inequality. This is an area of future study and development.

1.1. Literature review

This paper connects two important subjects in the urban economics literature: cities’ character-
istics (such as amenities and limited housing supply) and the heterogeneity in workers’ skills.
While extant research has shown that the physical geography of cities relates to their economic
outcomes (Albouy et al., 2019; Ganong & Shoag, 2017; Hornbeck & Moretti, 2015; Saiz, 2010),
a separate strand of the literature has focused on studying what determines the sorting of hetero-
geneous agents.2 Eeckhout et al. (2010), Behrens et al. (2014) and De la Roca et al. (2014)
develop (theoretical) discrete agent models that explore how locations’ fundamentals connect
to productivity and inequality in cities.3
Our paper closely relates to Davis and Dingel (2019) in using a continuum of skill types but
departs from this study by providing a microfounded housing market in which a restricted hous-
ing supply implies that, in equilibrium, a city may feature excess demand for housing (as in the
superstar cities framework).4 As we can fully characterise and compute the unique equilibrium of
the model using differential equations, we provide a tractable framework that is useful for quan-
titative policy evaluation. This analysis is exclusive to our setting.
This paper also relates to the literature that examines how city-level outcomes aggregate.
Hsieh and Moretti (2015) use a Rosen–Roback framework to analyse the role of cities in aggre-
gate growth. We contribute to this literature by providing a theory in which city productivity is
endogenous to the interaction between sorting and local agglomeration externalities. A parallel
literature has been studying wage inequality in cities (Baum-Snow & Pavan, 2013). Our model is
also able to generate vibrant patterns in the distribution of wages both within and between cities.
Furthermore, it predicts that the relationship between wage inequality and the level of local
wages should follow a power function, which is consistent with the data.
Finally, this paper also speaks to a growing literature that seeks to evaluate the aggregate con-
sequences of place-based policies. Despite many examples of local programme evaluations, it is
hard to assess the general equilibrium effects of these types of policies.5 We contribute to this
literature by quantifying the aggregate potential consequences of local policy changes by
means of the spatial sorting of heterogeneous workers.
This paper is organised as follows. Section 2 presents the model and theoretical results. Sec-
tion 3 discusses the data, describes the empirical estimation and presents the main empirical
results. Section 4 discusses policy implications and then concludes.

SPATIAL ECONOMIC ANALYSIS

328 Santiago Truffa and Alexis Montecinos

2. MODEL

We consider an economy that contains N . 1 cities. Cities have a heterogeneous endowment of

housing supply Si and amenities ai . Non-tradable services are produced within each city.

2.1. Production within a city

We follow Costinot and Vogel (2010) closely to describe production within a city. In particular,
we assume that the economy is populated by a continuum of workers with skill s [ [s,
s] that can
freely move between cities. We denote the density of the endogenous supply of workers with skill
s [ [s,
s] in city i [ {1, ..N } by vi (s) ≥ 0. Workers produce a continuum of intermediate goods,
referred to as tasks, that are used to produce one final good per city. The intermediate tasks are
indexed by their skill intensity s [ S = [s, s
].
Producing the intermediate goods only require workers that, despite being perfect substitutes
of each other, vary in their productivity A i (s, s) . 0.6 The endogenous output of task s in city i,
denoted by Y i (s), is given by:


Y i (s) = A i (s, s)Li (s, s)ds, (1)
s[S

where Li (s, s) ≥ 0 is the endogenous number of workers with skill s who work on task s in city i.
The output of the final good in city i is given by a Dixit–Stiglitz production function:

1/(1−1)
(1−1)/1
Y i = ki [Y i (s)] ds ,
s[S

where 0 , 1 , 1 is the constant elasticity of substitution across tasks, and k is a city-level pro-
ductivity shifter capturing the effect of agglomeration externalities. In line with Kline and Mor-
etti (2014), we model the productivity shifter ki as a power function of the endogenous number of
workers Bi producing in city i, i.e.:
ki = (Bi )h , (2)
where we define:


B := V (
s) =
i i
vi (s)ds, (3)
s[S

and h is the exogenous agglomeration externalities parameter. We introduce the variable Bi to

ease notation.
We assume that markets are perfectly competitive and the large number of identical firms are
price takers. Thus, the total profit for the final good is given by:

1/(1−1)

(1−1)/1
Pi = ki [Y i (s)] ds − pi (s)Y i (s)d s,
s[S s[S

where pi (s) . 0 is the endogenous price of task s in city i. The total profits for the intermediate
tasks are:


P (s) =
i
[ pi (s)A i (s, s) − wi (s)]Li (s, s)ds,
s[S

where w (s) . 0 is the endogenous wage for a worker with skill s in city i.
i

It is worth noticing some important distinctions between the description of the production
within cities in our economy and the study of Costinot and Vogel (2010). First, we highlight

SPATIAL ECONOMIC ANALYSIS

 On the geography of inequality: labour sorting in general equilibrium 329

that the endogenous output of task Y i (s) is city-dependent. As a result, the output of the inter-
mediate tasks and of the final good depend on the endogenous distribution of workers with skill s
performing task s available in city i. Second, the output of a particular location can be amplified
or damped by the city-specific productivity shifter ki , which is absent in their study. Since the
density of the supply of workers vi (s) is endogenously determined in our model and not exogen-
ously set as in previous studies, the productivity shifter ki is also endogenised.
Our model’s tractability relies on the specification of Costinot and Vogel (2010) where pro-
duction within cities depends on a continuum of workers and intermediate goods (i.e., tasks).
This framework allows us to transform the analysis of the competitive equilibrium into a match-
ing problem. In particular, the authors show that there exists a continuous and strictly increasing
matching function M i :S  S satisfying:

(i) Li (s, s) . 0 if and only if M i (s) = s, and

(ii) M i (
s) = s

and M i (s) = s,

such that the matching function M i (s) and the wage function wi (s) in each city solve the
following pair of differential equations:
dM i A i (s, M i (s))V i (s)
=  ,
ds [ pi (M i (s))]−1 s[S wi (s)vi (s)ds
(4)
d ln wi (s) ∂ ln A i [s, M i (s)]
= .
ds ∂s
Intuitively, since M i (s) = s, the matching function M i (s) maps a skill s to a task s through the
distribution (and density) of workers V i (s) (and vi (s)), the endogenous price pi (s) of task s, and
the productivity factor A i (s, s).7
The matching problem design of the production sector in conjunction with a housing market
modelled as a direct-search mechanism allows us to characterise the equilibrium in semi-closed
form.

2.2. Housing market

There are two main frameworks extensively used in the literature to model housing markets.
The first option is to assume that perfectly competitive firms produce housing goods with a
constant return to scale production function (e.g., Epple et al., 2010; Fajgelbaum & Gau-
bert, 2020; Favilukis et al., 2017; Giannone, 2019). By clearing the housing market with a
zero-profit condition, the housing supply has to adjust to the point of zero rents. In reality,
this adjustment process does not always hold true since market frictions, such as regulatory
restriction, physical limitations, and the time-to-build constraints generate a housing market
where rents are positive. While this framework represents a convenient abstraction of a lar-
gely heterogeneous housing market, it precludes researchers from investigating the impact of
non-zero rents to equilibrium quantities, such as wage dispersion and spatial distribution of
workers.
To circumvent this challenge, a second approach consists of describing the housing market as
a directed-search model (e.g., Albrecht et al., 2007; Caplin & Leahy, 2011; Diaz & Jerez, 2013;
Wheaton, 1990; Williams, 1995). As explained by Albrecht et al. (2016), the pricing mechanism
resulting from a direct-search model better reflects the way houses are bought and sold in the US.
The key principle of these models is that buyers and sellers search for matches and through their
bargain process house prices are determined. Thus, the assumption of zero rents is relaxed. We
use the direct-search mechanism to establish a link between the distribution of buyers (i.e.,
workers that can afford a house in the city centre) and house prices of a particular city.

SPATIAL ECONOMIC ANALYSIS

330 Santiago Truffa and Alexis Montecinos

The description of the housing market is identical to Albrecht et al. (2016) and is as follows.
The tightness of the housing market in city i is given by:

Bi
ui = , (5)
Si
where Bi is the total number of workers that bid for houses in city i, and Si is the total amount of
houses for sale.8 While the housing stock Si in each city is fixed and exogenously given, the total
number of workers Bi bidding for housing in city i is endogenously determined, as discussed in
the previous section. As a result, the housing market tightness ui is also an endogenous quantity
in our model. In addition, since ui depends on the total number of workers who arrive in equili-
brium to produce in city i, we assume that workers have rational expectations and correctly antici-
pate the value of ui in equilibrium before moving into a city.
The game has the following stages:

(1) Buyers randomly arrive to compete for a house.

(2) Each buyer of type s has a private valuation wi (s), which corresponds to the buyer’s wage in
city i. Buyers do not observe the number of other visitors to the house and do not coordinate
among themselves.
(3) As buyers arrive at a house, they compete for it through a first-price auction with an
unknown number of competitors. The house is transferred to the highest bidder.

Albrecht et al. (2016) show that the optimal bid bi (wi (s)) associated with a buyer of type s is:

F i (wi (s))
bi (wi (s)) = wi (s) − , (6)
f i (wi (s))

where F i (·) is the (endogenous) cumulative continuous distribution with support [0, 1] of the
match-specific value wi (s), and f i (·) is its first derivative. Rearranging this equation and defining
the worker’s disposable income xi as wage net housing costs, it follows that:

F i (wi (s))
xi := wi (s) − bi (wi (s)) = . (7)
f i (wi (s))

Since buyers’ valuations for a house are sampled from a common distribution F i (wi (s)), we have a
‘Poisson race’ among different players who arrive following the same arrival rate ui (i.e., the
endogenous housing market tightness) (Albrecht et al., 2016, sect. 3.2). This implies that the
probability that a buyer of skill s makes the highest bid bi (wi (s)) and wins the auction is given by:

P(H |s) = e−u (1−F (w (s))) ,

i i i
(8)

where H denotes the event that a particular worker draws the highest valuation.
The probability in (8) has two critical features in our context. First, it depends on the
endogenous housing market tightness ui = Bi /Si , which also corresponds to the arrival rate of
buyers in city i. When a particular city has a large number of workers Bi , the housing market
tightness ui is also high. As a result, the arrival of potential buyers is also high, which reduces
the probability of a worker with skill s to draw the highest valuation for a house. Second, this
probability depends on the endogenous match-specific distribution F(wi (s)). Thus, a high-
skilled worker that receives a high wage wi (s) has a higher probability of drawing a match-specific
value (i.e., F i (w(s)) is closer to 1). As a result, the probability of winning the auction P(H |s) is
larger.

SPATIAL ECONOMIC ANALYSIS

 On the geography of inequality: labour sorting in general equilibrium 331

We call the reader’s attention that the production sector and the housing market are tight
together through the number of workers Bi in each city i, the wage schedule wi (s), and
F i (wi (s)). Similar to the expressions in section 2.1, the functional form of (8) (i.e., the exponen-
tial form generated by the Poisson race) is critical for tractability.

2.3. Workers’ preferences

Workers have preference over the quality of local amenities ai and their disposable income xi .
The workers’ utility function is given by:
i
u(xi ) = xi eTa , (9)
where T is a deep preference parameter capturing the trade-off between disposable income and
i
the quality of local amenities.10 The term eTa can be interpreted as a utility shifter driven by ame-
nities ai and the deep preference parameter T .
To enjoy the amenities of a particular city, workers need to own a house in the city. If they
cannot afford a house, they have to live in the suburbs and receive zero utility. Workers are risk-
neutral with respect to living in the suburbs or not.
Since the probability of a worker of skill s making the highest bid for a house, winning the
auction, and consequently living in the city centre is given by P(H |s) as in (8), Bayes’ Theorem
allows us to write the worker’s utility in (9) as:
i
u(xi ) = U (wi (s)) = (wi (s) − bi (wi (s)))eTa P(H |s)
(10)
= (wi (s) − bi (wi (s)))eTa e−u (1−F (w (s)))
i i i i

where we define U (wi (s)) := u(xi ). Substituting (7) in (10), the worker’s utility becomes:
F i (wi (s)) Tai −ui (1−F i (wi (s)))
U i (wi (s)) = e . (11)
f i (wi (s))
Last, since wage wi (s) is a monotone function of talent s, there exists a function V i ( · ), such that
V i (s) = F i (w(s)). Consequently, we can rewrite (11) as:
V i (s) Tai −ui (1−V i (s))
Ui (s) = e , (12)
vi (s)
where we define Ui (s) := U i (wi (s)). Expression (12) shows that the utility of a worker living in
city i depends on the city characteristics (i.e., amenities ai ), the endogenous market tightness ui ,
and the endogenous distribution of skills s of a particular city V i (s).

2.4. Equilibrium
We introduce next the concept of equilibrium in this economy. Since there is free mobility, the
utility of a worker of ability s must be equal across space. Given that, by assumption, all cities
share the same support of skills [s,
s], all workers must be indifferent between all cities in
equilibrium.11
We define the equilibrium similar to Epple and Platt (1998), Calabrese et al. (2006) and
Costinot and Vogel (2010).
Definition 2.1. An equilibrium is a set of probability density functions {vi (s)}i[{1,..,N } of the workers’
type, production functions {Y i (s)}i[{1,..,N } , intermediate tasks’ prices { pi (s)}i[{1,..,N } , wages
{wi (s)}i[{1,..,N } and labour demand schedules {Li (s, s)}i[{1,..,N } , a set of optimal bids
{bi (x)}i[{1,...,N } , and the market tightness {ui (s)}i[{1,..,N } of each city, such that:

SPATIAL ECONOMIC ANALYSIS

332 Santiago Truffa and Alexis Montecinos

(1) Households choose their city of residence to maximise the utility in (10), subject to a positive
disposable income constraint xi ≥ 0.
(2) Final good producers maximise profits and final good market clears in all cities:
 1/(1−1)
(1−1)/1
Y i = ki s[S [Y i (s)] ds .
(3) Intermediate
 producers maximise profits and intermediate good market clears in all cities:
Y i (s) = s[S A(s, s)Li (s, s)ds. 
(4) Labour market clears in all cities: vi (s) = s[S Li (s, s)d s.
(5) The optimal bid in each city satisfies (6).

The next proposition presents the solution for the equilibrium in our economy.
Proposition 2.2. (Equilibrium Solution)
The probability density functions {vi (s)}i[{1,...,N } of the workers’ type in each city solve the following
system of ordinary differential equations (ODEs):
⎛ ⎞
  S j=i uj (1 − V j (s)) S j=i aj
SNj=1 vj (s)
s2 ⎜ vi (s) − + ui (1 − V i (s)) + T [ai − ]⎟
− ⎝ e N −1 N −1 ⎠
N −1 2 P j=i (V j (s))1/N −1
vi (s) = ⎛ ⎞ .
S j=i uj (1 − V j (s)) S j=i aj
⎜
i + u i
(1 − V i
(s)) + T [a i
− ]
N −1 ⎟
1 V (s) −
⎝1 + e N −1 ⎠
N − 1 P j=i (V j (s))1/N −1

The characterisation of the probability density functions in Proposition 2.2 allows us to deter-
mine all other equilibrium quantities. The total number of workers Bi in each city follows
immediately from (3), which pins down the market tightness in (5) and the productivity shifter
in (2). Since profit maximisation by final good producers in each city requires that:


Y i (s) = pi (s)−e wi (s)vi (s)ds, ∀s [ S, (13)
s[S

and the intermediate producers profit maximisation requires that:

pi (s)A i (s, s) − wi (s) ≤ 0, ∀s [ S,

(14)
pi (s)A i (s, s) − wi (s) = 0, ∀s [ S such that Li (s, s) . 0,

it follows that the price of intermediate tasks p i (σ), the productivity Ai (s, σ), the labour demand
Li (s, σ), and the wage function wi (s) are fully determined by (1), (4), (13), and (14). With the
characterisation of the wage schedule wi (s), the match-specific distribution F i (·) follows
immediately from the equality F i = V i ◦ (wi )−1 . Last, the optimal bid b(wi (s)) follows from
(6) since both the market tightness ui and the distribution F i (·) are now fully determined.
This concludes the characterisation of all equilibrium quantities.
Proposition 2.2 presents a critical insight of our model. The expression for the probability
density function vi of the workers’ type in each city depends on all cumulative probability distri-
butions (V 1 , V 2 , . . . , V N ) and the primitive parameters of the model (i.e., amenities ai and the
deep parameter T ). As a result, all other equilibrium quantities, such as wage schedules, labour
demand, intermediate tasks’ prices, and optimal bids in each city also depends on the talent dis-
tribution within and across cities.

SPATIAL ECONOMIC ANALYSIS

 On the geography of inequality: labour sorting in general equilibrium 333

3. EMPIRICAL ANALYSIS

3.1. Data
We use the Current Population Survey (CPS) for March 2011. The CPS provides the
wages for each MSA as well as the number of years of completed education, which we
use as a proxy for talent. The relative value of amenities in each MSA ai is proxied by
the hedonic parameters computed by Albouy (2016).12 The measure comprises two parts:
an endogenous productivity component (dependent on the workforce skill composition)
and a quality-of-life component. We use the second component of this amenity index,
since it is exogenous to the sorting of talent.
The last exogenous measure required by our model is a proxy for the new housing stock in
each MSA. Using the housing supply elasticities estimated by Saiz (2010), we assume that the
supply of new houses in each MSA is proportional to the product of the housing elasticity
and the existing housing stock provided by the American Housing Survey.13

3.2. Calibration
There are two main sets of parameters in our model: (1) general parameters that have already
been estimated in literature, such as the elasticity of substitution between services or skills 1,
and the local agglomeration externalities h; and (2) new parameters that are exclusive to our
theoretical specification, such as the relative taste for amenities T and the complementarity
between workers’ skills and job complexity A.
To calibrate the parameters in the first group, we simply follow the literature. First, we fix the
elasticity of substitution between services at 1 = 2. Several authors, such as Katz and Murphy
(1992) and Ciccone and Peri (2006), have estimated the elasticity of substitution between skilled
and unskilled workers in the range of [1,2]. More recently, Hsieh and Klenow (2009) use an elas-
ticity of substitution between manufacturing goods equal to 3. Our results are robust to the spe-
cification of this elasticity for values in the interval [1,3].
For the agglomeration externalities parameter h, we follow Kline and Moretti (2013), who
show that the elasticity of agglomeration externalities with respect to density is constant, and
we fix it at h = 0.08. As shown in section 2.1, agglomeration externalities are modelled as a
city-level productivity shifter ki = (Bi )h .
There are two main implications of adopting this functional form for representing
agglomeration externalities. First, it implies that a city’s density makes workers more pro-
ductive, because the productivity shifter is a monotonic increasing function of the city
size. Second, it affects workers differently due to the curvature of the power function.
High-skilled workers experience higher productivity gains from these local shifters relative
to low-skilled workers.
To calibrate the parameters in the second group, we perform an indirect inference esti-
mation. We exploit the fact that our model can be solved in two separate parts (i.e., the
spatial sorting of workers and the competitive equilibrium in each city) and split the esti-
mation procedure into two parts as well. In the first part, we solve the spatial sorting pro-
blem and recover only the parameter capturing the taste for amenities. Once we achieve an
endogenous distribution of skills for each MSA, we solve for the distribution of wages in
each city afterward, because the cities produce non-tradable services. From these wage dis-
tributions, we recover the second parameter representing the skill–technology complementar-
ity. Our indirect inference estimation produces a taste of amenities T = 7 and a job
complexity A = 1.36. Table 1 summarises the key parameters of our calibration, and Appen-
dix C in the supplemental data online contains a detailed description of the estimation pro-
cedure. The skill level is normalised to the interval [0,1].

SPATIAL ECONOMIC ANALYSIS

334 Santiago Truffa and Alexis Montecinos

Table 1. Key parameters used in the calibration exercise.

Description Symbol Value

Elasticity of substitution between services 1 2

Agglomeration externalities h 0.08
Taste of amenities T 7
Job complexity A 1.36

3.3. Results
The calibrated model allows us to investigate not only the relationship between the endogenous
quantities, such as the distribution of wages, housing prices, and the distribution of talent by
MSA, but also how these variables respond to changes in the city’s fundamental characteristics,
such as the tightness of the housing market. As discussed in section 2.2, we measure the housing
market tightness of city i with the equilibrium ratio between buyers and sellers. Thus, the
measure ui reflects both dimensions of the city characteristics (i.e., amenities and limited housing
supply), since high-theta cities are the result of high amenities and a restrictive housing supply.
Figure 1 shows skill distributions predicted by the model for a subset of high-theta cities in
Figure 1a and low-theta cities in Figure 1b. Figure 1a reveals that superstar cities feature talent
polarisation, with ‘U’-shaped skill distributions. Thus, the skill distribution of high-theta cities

Figure 1. Talent distributions: (a) probability density function for a sample of four high-theta cities;
and (b) probability density function for a sample of four low-theta cities. The support of the talent
distribution is the interval [0,1].

SPATIAL ECONOMIC ANALYSIS

 On the geography of inequality: labour sorting in general equilibrium 335

Figure 2. Within-city wage and housing price dispersion as a function of theta.

displays ‘fat tails’ for both high- and low-skilled workers. In fact, the density of the high-theta
cities is the highest for highly skilled workers (i.e., with s [ [0.75,1]). On the other hand,
Figure 1b shows that the skill distribution of low-theta cities has an inverted ‘U’-shape. In
essence, the plot indicates that non-superstar cities tend to have a large density of average skilled
workers, while lacking very high- and low-skilled workers. This is important for two reasons.
First, super star cities feature (in an almost extreme way), fat tails. That is indeed consistent
with different findings in the literature Eeckhout et al. (2010). Second, these distributions
drive within city inequality. In particular, fat tails mean that there is a mass of high earners
and a mass of low earners in super star cities, which drives wage inequality in these places.
The heterogeneity among skill distributions in superstar and non-superstar cities has pro-
found consequences for the dispersion of two key economic variables: wage and housing price.
Since one of the main objectives of our work is to investigate the link between the sorting of
talent and inequality across cities, we show in Figure 2 how city characteristics affect within
city dispersion of wage and housing prices.
Figure 2a shows that superstar cities (i.e., high-theta cities) have the largest wage dispersion
and, consequently, are more unequal places. Figure 2b shows that the dispersion of house prices is
higher in superstar cities. It is worth noticing that, in both panels, there is a clear linear relation-
ship between the house price and u, which suggests that city characteristics, such as amenities and
limited housing supply, are critical factors explaining wage and housing price dispersion across
cities. Together, the graphs indicate that, although workers are indifferent between cities in equi-
librium, their disposable income (i.e., wages net housing expenses) varies considerably in the
cross section. Overall, we observe that sorting not only generates between-city differences, but
also causes important variation within cities.
To further explore the impact of amenities and limited housing supply (i.e., ui ) on inequality
between cities, we investigate how the disposable income of the 20% poorest households in each
city correlates with the amenities and the housing supply of that particular location. In essence,
we want to know if the 20% poorest (richest) workers in a high-theta city earn more than the 20%
poorest (richest) workers in low-theta cities. Figure 3 presents the answer to this question.
Figure 3a shows that the disposable income of workers in the 20th percentile of the talent
distribution in low-theta cities is significantly lower than its counterpart in high-theta cities.
The reason is that the low supply of low-skilled workers makes their relative talent very valuable
in high-theta cities, which is reflected in high relative prices and wages.
Figure 3b shows that the effect of ui on the disposable income of the 20% richest workers in
each city is the opposite of that on the 20% poorest workers. Workers in the 80th percentile of

SPATIAL ECONOMIC ANALYSIS

336 Santiago Truffa and Alexis Montecinos

Figure 3. Disposable income as a function of theta.

the talent distribution have lower disposable income in superstar cities (i.e., high-theta cities).
The reason is that they tend to pay a higher fraction of their wages for living in the city centre.
As a result, they become very sensitive to amenities and are willing to sacrifice some income to
enjoy urban living.
To understand which of these two groups of workers are affected the most by variations in ui ,
in Figure 3c we plot the ratio between the disposable income of workers in the 80th and 20th
percentile. As shown, this ratio is a decreasing function of ui , which indicates that the effects
of ui on the wages of low-skilled workers outweigh the changes caused in the disposable income
of high-skilled workers. Despite the fact that superstar cities are more unequal places due to their
bimodal talent distributions, the sensitivity of high-skilled workers to amenities tends to counter-
act the inequality caused by the sorting of heterogenous agents between cities, ultimately dimin-
ishing the differences in disposable income between high- and low-skilled workers.

3.3.1. Unpacking sorting effects

Since the location decisions of workers are not driven by local productivity differences, but rather
by city characteristics (i.e., amenities and limited housing supply), our framework allows us to
separate what fraction of the wage dispersion between cities is due to the sorting of hetero-
geneous agents and what fraction of the wage dispersion is due to local agglomeration external-
ities. To obtain the former fraction, we fix the size of each city and impose the same skill
distribution everywhere. With the model lacking sorting effects, we recalculate the dispersion
of wages and housing prices both between and within cities. Our numerical results show that,
in the absence of sorting effects, the total wage dispersion between cities drops by 7.5%, and

SPATIAL ECONOMIC ANALYSIS

 On the geography of inequality: labour sorting in general equilibrium 337

housing price dispersion between cities drops by 5.7%. While wage inequality and dispersion in
housing prices decline, the overall economy experiences a fall in aggregate productivity, with the
total gross domestic product (GDP) dropping 1.9%. The reason for this substantial difference is
that the most productive workers tend to cluster in larger cities when we allow for the sorting of
heterogenous agents. In those large metropolitan areas, the agglomeration externalities boost the
workers’ marginal productivity, which results in a higher aggregate output.
Our numerical analysis shows that the city characteristics have a profound effect on the level
and dispersion of wages within cities as well. In particular, superstar cities experience an average
wage increase of around 20–40% with sorting, whereas non-superstar cities oscillate between –
10% and 10%. For cities with ui . 3 (i.e., high amenities and low housing supply), the wage
inequality within cities is between 20% and 40% higher due to talent sorting. On the other
hand, in cities with ui , 2, talent sorting induces a predominantly negative effect on wage dis-
persion, indicating that wage inequality is reduced in those metropolitan areas due to the
accumulation of low-skilled workers. Thus, while the sorting of heterogenous agents contributes
to the wage inequality within superstar cities, it promotes wage equality in non-superstar cities.
Last, house prices in superstar cities are significantly affected by the sorting of talent as well. For
cities with ui . 2, we find that talent sorting increases average housing prices by 20–40% due to
the intense bidding wars.
We finish this section presenting the effects of agglomeration externalities on wage level and
dispersion. To assess that, we set the agglomeration externality parameter to zero and re-evaluate
the equilibrium in an economy that features sorting in the absence of agglomeration externalities.
We then compute the change in average wages and wage dispersion relative to the benchmark
economy that features talent sorting and agglomeration externalities. Our numerical experiment
shows that changes in average wages between cities is, on average, 17% higher in the presence of
agglomeration externalities, while changes within cities on wage dispersion is, on average, 7%
higher. Overall, these two forces seem to complement each other.

3.3.2. Place-based policies: national housing

In this section, we evaluate the consequences of changes in the local housing supply to aggregate
variables, such as productivity and wage inequality. In particular, we independently shock each
city with an increase in housing supply equivalent to 1% of the national housing stock and evalu-
ate the response to the aggregate output and wage dispersion within cities. Figure 4 presents the
results of this experiment.

Figure 4. National housing policy: aggregate effects of shocking housing supply by city type as a func-
tion of theta.

SPATIAL ECONOMIC ANALYSIS

338 Santiago Truffa and Alexis Montecinos

Figure 4a shows the effects of the increase of 1% in the housing supply of a particular city on
the aggregate output (i.e., GDP). As illustrated, for the majority of the cities where the housing
constraints are not binding (i.e., ui , 1), the housing shock does not generate significant effects
on the GDP. In those cities, aggregate effects are very close to zero. Interestingly, for cities where
the housing constraints are binding but the shortage of housing is not as severe (i.e.,
1 , ui , 1.5), aggregate output decreases by approximately 0.4%. The reason is that expanding
the housing supply does not change the number of workers in the economy, but rather changes
the characteristics of the local housing markets. The reallocation of workers induced by those
changes in city characteristics can generate higher or lower productivity as the result of the inter-
action between skill sorting and endogenous local agglomeration externalities. By relaxing hous-
ing constraints in those cities, we make them more attractive to skilled workers. As a result, some
skilled workers stay away from larger urban centres, and the productivity gains to the overall
economy coming from agglomeration externalities is partially lost, resulting in a decline of the
GDP. Lastly, the graph shows that expanding the supply of houses in high-theta cities (i.e.,
ui . 2), the economy grows between 0.2% and 0.4% more. By increasing the housing supply
in superstar cities, we expand the accessibility of these productive environments to more workers.
As these cities grow, they also become more productive.
Although it is the case that expanding superstar cities generates gains in aggregate pro-
ductivity, this expansion comes at the cost of higher local wage inequality. Figure 4b shows
the change in ex-post aggregate wage dispersion after a housing shock. As before, a housing
supply shock in places where the housing constraints are not binding has no effect on aggregate
wage inequality. As we move to high-theta cities, we find that inequality is higher for cities fea-
turing tighter housing constraints. In particular, these cities experience an influx of low-skilled
workers, creating a negative congestion in the city they move to. As the relative supply of
high-skilled workers decreases in large cities, their salaries increase. At an equal rate, low-skilled
workers have their salaries depressed by the expansion of their relative talent supply.
Overall, while relaxing housing constraints in superstar cities generates important gains in
aggregate production, these policy changes also entail adjustments in the composition of the
local labour force that ultimately generate the unintended consequence of increasing wage
inequality within the city.

3.3.3. External validity

We must investigate capacity of the calibrated model for predicting patterns that were not tar-
geted in the original exercise. To evaluate this, I focus on two important predictions: the relative
size of cities and their relative housing prices.
Figure 5 plots the predicted versus real city size and average housing prices. The model per-
forms well in terms of predicting both relative city sizes and relative housing prices.
Finally, we believe the model is able to replicate an internal pattern which seems incredible
interesting. And that it, it seems to be a positive relation between wage level and wage dispersion
at the city level. That is, cities that feature higher wages on average, also feature higher wage
inequality. Moreover, as Figure 6a show, this seems to be a linear pattern. Using the CPS for
March 2011, we plot this correlation. Figure 6b shows the relation between average wages
and wage dispersion that the model predicts. Although it does not perfectly replicate the data,
the same pattern seems to hold.

3.3.4. The welfare consequences of relaxing housing constraints

To understand how housing constraints affect welfare, we perform a very peculiar experiment.
We assume that housing supply can perfectly accommodate housing demand. To do so, we
assume that housing supply is so flexible, that theta is always 1. In this scenario, total production
goes down 4.04% and wage inequality falls 7.1%. Aggregate welfare goes up by 0.000003955%.

SPATIAL ECONOMIC ANALYSIS

 On the geography of inequality: labour sorting in general equilibrium 339

Figure 5. External validity: (a) observed relative city sizes (from Census 2010) versus predicted relative
city sizes; and (b) observed relative average housing price from the Zillow housing price index versus
the relative housing prices predicted by the model.

Figure 6. City level average wage versus city level wage dispersion predicted by the model versus the
correlation observed in the data. Graphs are in logarithmic scale: (a) relation between average wages
and wage dispersion for the March 2011 CPS; and (b) relation between average wages and wage dis-
persion as predicted by the model.

Figure 7. Aggregate welfare by city size.

SPATIAL ECONOMIC ANALYSIS

340 Santiago Truffa and Alexis Montecinos

Figure 8. Welfare by worker type.

Now it is no longer the case that welfare is ordered by city size. Indeed, if we compute the change
in welfare by city size, we see clear distributive effects taking place, with small cities being better
off, and big cities worse off.
Since housing supply constraints changes the composition of workers that live in cities, when
we relax these constraints there is a reordering of workers in space. In this scenario, big cities have
a considerable average welfare loss, and it has to do with that fact that less high skill workers con-
centrate in those places. Although overall welfare remains almost constant, there is a considerable
welfare transfer between city types. This simple exercise underscores an important point. There is
a political cleavage between big and small cities regarding national housing policy, since big cities
are better off imposing restrictions on housing supply. Finally, we will see how relaxing housing
constraints affect different types of workers. We see that the relaxation of housing constraints
leaves low skill workers better off. Although aggregate welfare changes slightly, there are distri-
butional effects from high skilled workers to low skill workers.

4. CONCLUSIONS

In this paper, we examine how city characteristics, such as housing supply and local amenities,
affect the sorting of heterogeneous agents between cities. We develop an urban macro model
in which cities have a restricted supply of houses, and workers with a continuum of skills compete
for limited space through bidding wars. In this context, the pecuniary congestion costs that het-
erogeneous workers impose on each other operate as an endogenous driver for gentrification. The

SPATIAL ECONOMIC ANALYSIS

 On the geography of inequality: labour sorting in general equilibrium 341

model has a unique equilibrium that can be calibrated to match different moments of the talent
and wage distribution for a cross section of US cities.
Overall, our numerical simulations stress that the sorting of heterogeneously skilled workers
can generate sizable aggregate effects on productivity and inequality, mostly driven by the inter-
action between sorting and local agglomeration externalities. In particular, we find that the sort-
ing of heterogeneous workers accounts for 7.5% of the total variation and generates considerable
differences between cities. Sorting mostly affects cities that feature tighter housing markets,
making them between 20% and 40% more productive. In the absence of sorting, aggregate pro-
duction falls by 1.9% due to the loss in agglomeration externalities resulting from the reallocation
of high-skilled workers from large urban areas to small cities.
–Finally, we use the calibrated model to evaluate place-based policies. We find that policies
designed to improve labour mobility, such as the expansion of housing in constrained urban
centres, can have unintended consequences to wage inequality, given the sorting of heteroge-
neously skilled workers in the presence of local agglomeration externalities. In particular, we esti-
mate that expanding the housing supply in cities with tighter housing markets increases
productivity between 0.2% and 0.4%. This increase is mitigated by sorting as high-skilled
workers tend to relocate to cities where they are less productive. Although these policies aim
to reduce inequality by facilitating the spatial mobility of workers, they can produce an unex-
pected increase in aggregate wage inequality by the same magnitude.

ACKNOWLEDGEMENTS

We are extremely grateful to Ernesto Dal Bó, William Fuchs and John Morgan for their support.
We also thank Scott Baker, Victor Couture, Cecile Gaubert, Rui de Figueiredo, William
Grieser, William Hardin, Enrico Moretti, Gonzalo Maturana, Steve Tadelis, Joachim Voth,
Reed Walker, Zhonghua Wu and Noam Yuchtman, as well as numerous seminar and conference
participants, for their helpful discussions and comments. We would also like to thank Diogo
Duarte who contributed to this project on an earlier version. This paper was originally part of
Santiago Truffa’s PhD dissertation titled ‘Essays in urban economics’.

DISCLOSURE STATEMENT

No potential conflict of interest was reported by the authors.

NOTES
1
In this study we will focus on wage and housing price inequality. In particular, since we are
able to compute wages at the individual level, we can analyse both between- and within-city
inequality. When we refer to aggregate inequality, we mean the total variance of all individual
wages.
2
Shapiro (2006), Glaeser and Gottlieb (2008), Couture (2015), Albouy et al. (2016) and
Albouy (2016) have empirically shown the importance of amenities in accounting for sorting
patterns. We build on this literature, and we quantify the trade-off between amenities versus
restrictions on the housing supply. Related literature has explored the sorting of heterogeneous
firms (Behrens et al., 2014; Gaubert, 2018; Serrato & Zidar, 2016) to study the welfare impli-
cations of taxes and firm incentives. We complement this literature by focusing on the worker
side. Further work is required to join these two threads in the literature.
3
Frameworks that divide the workforce into discrete categories are empirically sensitive since
the results depend on dichotomous definitions of what type of worker qualifies for each type

SPATIAL ECONOMIC ANALYSIS

342 Santiago Truffa and Alexis Montecinos

of category. Indeed, Baum-Snow et al. (2018) show that if we change the definition of high-
skilled worker to a worker with some college education, some of the results shown by Diamond
(2016) no longer hold.
4
To do so, we follow recent literature that models the housing market with bidding wars. For a
review, see Han and Strange (2015).
5
A notable exception is Kline and Moretti (2014), who develop a methodology to estimate
their aggregate effects.
6
Similar to Costinot and Vogel (2010), we assume that A i (s, s) . 0 is twice differentiable and
strictly log-supermodular to capture the idea that high-skill workers have a comparative advan-
tage in more complex tasks. This feature partially compensates for the fact that we have a com-
mon agglomeration elasticity and do not differentiate between low- and high-skilled workers’
elasticities.
7
Notice that Li (s, s) = vi (s)1{M i (s)=s} , where 1 is an indicator function. Also, notice that
B = V i (
s).
i
8
Following Albrecht et al. (2016), we assume that Bi and Si are large enough so that the arrival
rate of buyers visiting a particular seller follows a continuous Poisson process with parameter ui .
10
The preference in (9) is a monotonic transformation of the homothetic preference
U = Tai log (xi ) commonly adopted in the literature. Thus, all the properties of this utility
representation are preserved under the monotonic transformation in (9).
11
In fact, this is consistent with empirical distributions of talent, as shown by Bacolod et al.
(2009). Although we see differences between cities in the fraction of high- to low-skilled
workers, we still observe a positive mass of workers at every level of talent. Moreover, if we restrict
attention to two cities, we can prove that for any pair of non-overlapping skill distributions, this
configuration is never in equilibrium, since the lowest-skilled worker in the high-skilled city will
always have an incentive to move to the low-skilled city, where she is the most skilled worker. We
present the two cities case in the Appendix in the supplemental data online.
12
The author develops a methodology that derives hedonic measures of local productivity and
local amenities from data, such as local wages, housing prices and taxes. The quality-of-life
measure positively correlates to measures of natural amenities relating to climate and geography.
13
This measure stems from satellite-generated data on terrain elevation and the presence of
water bodies to estimate the amount of developable land in each MSA. We focus on the part
of the elasticity that is determined by geographical restrictions.

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