Full Solution of an Endogenous Sorting Model with Contextual and Income Effects

The paper solves analytically a problem where individuals sort themselves into neighborhoods because they value average schooling among adults in the neighborhood. The paper extends results by Nesheim (2002) but with the addition of income effects on neighborhood choice. Individuals value housing, non-housing consumption, and expected schooling of their children. The latter depends on parental schooling, on a child’s ability, and on average schooling in the neighborhood. Neighborhood choice trades off non-housing consumption with children’s expected schooling. Individuals choose neighborhoods recognizing that their neighbors’ characteristics are correlated with their own. The equilibrium housing price is associated with endogenous sorting and also allows computation of neighborhood distributions of income, of schooling and other variables of interest. * The results of this paper were reported originally in my “Neighborhood Effects and Housing,” version March 3, 2008, Handbook of Social Economics, Jess Benhabib, Alberto Bisin, and Matthew O. Jackson, eds., Elsevier, forthcoming. I thank Bryan Graham for sharing with me his “On the Identification of Neighborhood Externalities in the Presence of Endogenous Neighborhood Selection,” June 26, 2008. The usual caveats apply. IoannidesSolutionSorting-August-17-08.tex