A micro-foundation of local business cycles

Cyclical fluctuations in unemployment vary widely across cities in the United States. It is puzzling that after controlling for the industry composition effect, one can still find significant cyclical heterogeneity. This paper demonstrates how the temporal agglomeration externality due to the thick market effect, combined with idiosyncratic shocks across local firms, generates local business cycles. The paper formalizes the idea of a city as existing to facilitate matching between specialized inputs and firms in a fully dynamic framework; specifically, a sequence of multi-object auctions is used to model trading in the local market. The timing of auctions is endogenously determined. The paper shows that the size of the local economy is an important factor contributing to variations in patterns of cyclical fluctuations across cities.