Supply, Demand, Institutions, and Firms: A Theory of Labor Market Sorting and the Wage Distribution

This paper studies the long-run labor market effects of changes in the aggregate supply of skills, skill-biased demand shocks, and minimum wages. For that purpose, it builds a tractable general equilibrium model with worker and firm heterogeneity, monopsony power in the labor market, task-based production, and free entry of firms. In the model, the shocks affect the wage distribution not only through marginal products of labor but also through changes in the distribution of firm wage premiums across workers. Because of these "reallocation effects," a rising share of college workers might widen the average college premium instead of compressing it, and supply and demand shocks affect reduced-form measures of labor market sorting. In addition to the marginal productivity and reallocation channels, minimum wages cause disemployment of low productivity workers and increased employment of other workers due to monopsony power. The model is estimated using linked employer-employee data from Brazil, using regional and time variation for identification. The estimated model reveals substantial regional heterogeneity in the effects of minimum wages. It also shows that rising educational achievement dampened the adverse employment effects of a large increase in the national minimum wage from 2000 to 2012. Finally, skill-biased demand shocks led to rising assortativeness in the Brazilian labor market.