Two-sided sorting of workers and firms: Implications for spatial inequality and welfare

High-skilled workers and high-productivity firms co-locate in large cities. In this paper, I study how the two-sided sorting of workers and firms affects spatial earnings inequality, efficiency of the allocation of workers and firms across cities, and the welfare consequences of place-based policies. I build a general equilibrium model in which heterogeneous workers and firms sort across cities and match within cities. I estimate the model using Canadian matched employer-employee data and decompose the urban earnings premium, finding that worker and firm sorting account for 67% and 27% of this premium, respectively. The decentralized equilibrium is inefficient as low-productivity firms overvalue locating in high-skilled cities. The optimal spatial policy would incentivize high-skilled workers and high-productivity firms to co-locate to a greater extent while redistributing income towards low-earning cities, leading to a 6% increase in social welfare. Model counterfactuals underscore the importance of two-sided sorting when evaluating distributional and aggregate outcomes of place-based policies.