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This paper develops a theory of two-sided spatial sorting where heterogeneous workers and firms choose locations and match randomly within local labor markets. Spatial disparities arise endogenously across ex ante homogeneous locations. Productive workers and firms co-locate in cities due to production complementarities, making cities with high-quality search pools densely populated. Although spatial sorting improves allocative efficiency by facilitating positive assortative matching, concentration in cities is inefficiently high. Since workers and firms embody productivity, relocating them can mitigate congestion without reducing output. A comparison with models without either worker or firm sorting reveals that two-sided sorting yields distinct policy implications.

Using administrative data from Germany, we document that high-wage locations have substantially lower labor shares and higher wage dispersion. We show that a parsimonious model, in which firm monopsony power stems from search frictions in local labor markets, can explain these facts as long as “superstar” firms sort into productive locations. This positive sorting, which emerges as the unique equilibrium if firm and location productivity are sufficient complements or labor market frictions are sufficiently large, steepens the local wage ladder in productive locations and leads to not only higher wages, but also greater wage inequality. At the same time, positive firm sorting reduces local labor shares in prosperous places because more productive firms have more monopsony power. Our estimated model indicates that firm sorting can rationalize the lower local labor shares in regions with endogenously higher wages and can account for 40% of their increased wage dispersion. In spatial firm sorting, we thus highlight a new source of disparities in local labor market outcomes.

We develop a sufficient statistics approach to evaluate the impact of sectoral shocks on labor market dynamics and welfare. Within a broad class of dynamic discrete choice models that allows for arbitrary persistent worker heterogeneity, we show that knowledge of steady-state intersectoral gross worker flows over various time horizons is sufficient to evaluate labor supply responses to shocks and their welfare consequences. We also establish analytically that assuming away persistent worker heterogeneity—a common practice in the literature—leads to overestimation of steady-state worker flows, resulting in systematic biases in counterfactual predictions. As an illustration of our approach, we revisit the consequences of the rise of import competition from China. Using US panel data to measure steady-state worker flows, we conclude that labor reallocation from manufacturing to non-manufacturing is significantly slower, and the negative welfare effects on manufacturing workers are much more severe than those predicted by models without persistent worker heterogeneity.

Why are economic activities concentrated in space? What are the policy implications of this concentration? And how will it change in the future? We revisit these classic questions in the context of non-tradable services, such as restaurants and retail, in Seoul. To understand the spatial concentration, we first causally identify positive spillovers across services stores. We microfound these spillovers by incorporating the trip-chaining mechanism—whereby consumers make multiple purchases during their services travel—into a standard quantitative spatial model that determines the spatial distribution of services. When calibrated to an original survey on trip chaining, this mechanism explains one-third of the observed concentration. However, unlike standard agglomeration mechanisms, it does not lead to inefficiency nor it exacerbates welfare inequality. Finally, we show that spatial linkages of services consumption play a crucial role in shaping the impact of the rise of work-from-home and of delivery services on the distribution of services.