Survival of the Fittest in Cities: Agglomeration, Polarization, and Income Inequality

Using a large sample of US urban areas, we provide systematic evidence that mean household income rises with city ('agglomeration'), that this effect is stronger for the top of the income distribution ('polarization'), and that household income inequality increases at a decreasing rate in city size ('inequality'). To account simultaneously for these facts, we develop a microfounded model of endogenous city formation in which urban centres select the most productive agents. Income inequality is driven by both the 'poverty' and the 'superstar' margins: whereas the least productive agents fail in a tougher urban environment, which increases 'poverty', the most productive agents become 'superstars' who reap the benefits from a larger urban market. At equilibrium, the returns to skills are increasing in city size, thereby dilating the income distribution. Our model is both rich and tractable enough to allow for a detailed investigation of when cities emerge, what determines their size, how they interact through the channels of trade, and how inter-city trade influences intra-city income inequality.