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Local Labor Markets and Agglomeration Economies

Written By: Jason Shafrin - Nov• 01•10

If there is a boost in demand for a certain product, how will that affect wages?  This seems like a straightforward question.  However, a working paper by Enrico Moretti (2010) takes this analysis a step further by examining how labor market shocks affect the spatial component of the labor markets.

In general equilibrium, a shock to a local labor market is partially capitalized into housing prices and partially reflected in worker wages. While marginal workers are always indifferent across locations, the utility of inframarginal workers can be affected by localized shocks. The model clarifies that the welfare consequences of localized productivity shifts depend on which of the two factors of production—labor or housing—is supplied more elastically at the local level.  A lower local elasticity of labor supply implies that a larger fraction of a shock to a city accrues to workers in that city and a smaller fraction accrues to landowners in that city. On the other hand, a more inelastic housing supply implies a larger incidence of the shock on landowners, holding constant labor supply elasticity. This makes intuitive sense: if labor is relatively less mobile, local workers are able to capture more of the economic rent generated by the shock.

The paper also discusses the concept of agglomeration economies.  Thick labor markets are attractive for both firms and workers because each can find better matches and risk is lowered.  Better matches means that employers can find better employees and workers can find better job opportunities.   In the case where a worker is laid off, being in a thick labor market allows them to more easily search for jobs.  Not all large cities have thick markets for all types of labor.  For instance, although Detroit has 4.4 million people in its metro area and Washington, D.C. has 5.4 million, the Detroit labor market is much thicker for car workers, and the DC market is much thicker for public policy analysts.  Firms can also take advantage of thick markets by getting better quality/lower cost products from suppliers.  Think about the network of auto parts suppliers that has developed in Detroit.

So should the government provide subsidies to attract large firms and create agglomeration economies?   Moretti believes that these attempts will generally be unsuccessful.  If firms who move to a poor area are subsidized (e.g., through Empowerment Zones), jobs should increase.  As the demand for labor increases with the new firms, new workers will move to these previously poor areas.  The new supply of workers will need housing and thus rents will increase.  Thus, the former residents will have better job prospects, but a higher cost of living and the aggregate effect on welfare is ambiguous.  Landowners in the empowerment zone will benefit, however, landowners in other areas (who were taxed to fund these subsidies) will be worse off.


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