Can the Invisible Hand Correct Misallocations? Evidence from Labour Agencies in China

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Can market forces correct misallocations through endogenous institutional change? This paper explores this question by studying the expansion of labour agencies in a developing economy, and its impact on factor allocation and skill formation. Using a newly constructed dataset covering the near universe of labour agencies in China, I find that these intermediaries established branches to arbitrage the largest pre-existing inter-regional wage disparities, and channelled unskilled workers into auxiliary positions in the modern sector. However, while the expansion of agency networks facilitated labour mobility and reduced wage dispersions across cities, it perpetuated regional gaps in college attainment among the youth. I rationalize these findings with a dynamic framework with agency expansion and educational investment, and quantify the welfare impact of this particular way of factor reallocation. Labour market intermediaries emerged to promote regional wage convergence for unskilled labour, but may have exacerbated coordination failures in human capital accumulation, leading to static output gains but dynamic welfare loss.