The Dynamic Effects of Local Labor Market Shocks on Small Firms in the United States

Abstract

We use payroll data on over 1 million workers at 80,000 small firms to construct county-month measures of employment, hours, and wages that correct for dynamic changes in sample composition in response to business cycle fluctuations. We use this to estimate the response of small firms’ employment, hours and wages to tighter local labor market conditions. We find that employment and hours per worker fall and wages rise. To check this interpretation, we show that our results hold when instrumenting for local demand using county-level Department of Defense contract spending. Correction for dynamic sample bias is important—without it, the hours fall by only one third as much and wages increase by double. We also show that our findings are consistent with a simple model of labor markets with assortative matching of workers and firms.

Keywords: small firms, wages, hours, firm heterogeneity, private-sector establishment level data, business cycle.