Thursday, May 29, 2014

Regional Price Parities: Adjusting Wages for the Cost of Living

Tyson Smith, Regional Economist

We know that the dollar amount written on our paychecks obscures the true value of our wages.  For one, the price of goods and services generally increases over time, which means that a dollar today has more purchasing power than a dollar tomorrow. The economic term for price increases over time is inflation. If our wages do not keep pace with inflation, the value of our paycheck shrinks.

Secondly, we need to consider location when assessing the purchasing power of our wages. The price of a product or service in a specific region may be different than the price for the same product or service in a different location. Prices differ by location because geographical scarcities and localized consumer preferences can dramatically impact supply and demand[1].

                        (Click Image to Enlarge)
For example, most Americans spend a significant portion of their income on housing (rents, mortgages, etc.). In densely populated or fast growing regions, large numbers of people need housing. If the number of people looking for housing exceeds the number of accommodations available, then housing prices will be elevated. Conversely, regions with low population growth or density can more easily meet the housing needs of the population, which reduces the price of housing. The effects of geographical scarcity can be applied to every product and service in a local economy with varying degrees of impact on price levels.

The Bureau of Economic Analysis (BEA) uses Regional Price Parities (RPPs) to account for the cost of living in a specific location. RPPs measure the differences in the price levels of goods and services across states and metropolitan areas for a given year. RPPs are expressed as a percentage of the overall national price level, where the national average equals 100. State and metropolitan RPPs can be accessed on the BEA website, and the chart to the right shows the RPPs for each state in 2012. The 2012 RPP for Utah is 96.8, which means that average price levels in the state were 3.2 percent below the national average.

The data also allows for the examination of prices in metropolitan areas. The table below highlights the effects of regional price differences on median annual incomes for the five largest and smallest metropolitan areas in the U.S.[2], as well as the five Utah metropolitan areas. Each area in Utah has an RPP under 100, which means that a dollar in any of Utah’s metros has more purchasing power than the national average. Utah’s reasonable cost of living can be attributed to its relatively low housing costs[3], which were 7.9 percent below the national average.

(Click Image to Enlarge)
Adjusting for RPP reveals that the absolute values of Utah wages are misleading, because Utahns have greater purchasing power relative to national averages. So, next time you look at your paycheck keep in mind that the value of your wages depends on where you live and spend your money.

[1] Supply and demand are not the only determinants of prices, other factors – like regulations, government interventions, taxes, and imperfect competition (i.e. monopolies) – can influence price levels as well.
[2] “Five Largest” and “Five Smallest” regions determined by the estimated number of workers in the 2012 Occupational Employment Statistics survey conducted by the Bureau of Labor Statistics (minimum of 50,000 workers).
[3] RPP data on rents [housing costs] are obtained from the Census Bureau’s American Community Survey.

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