What’s Driving Cost of Living?


September 26, 2016

There are two sides to every paycheck. The first is how much you earn, a function often as much of where you live as what you do for a living.

The second is how far that dollar can go. Purchasing power is both a highly local affair and an incredibly important one. People who live in communities with higher costs of living save less because more of their paychecks get sucked up by the essentials.

Recently Glassdoor ranked the top 25 Cities Where Pay Goes the Furthest, measuring median income against local housing prices. Surprising cities like Detroit and Pittsburgh ranked highly thanks to low costs offset against increasingly strong take home pay. These aren’t cities most people would expect to do well on a study measuring quality of life.

Yet there they are, alongside Cleveland, St. Louis and several others as the cities where people can feel far wealthier than in headline destinations like Boston and San Francisco. While everyone knows that big cities are often expensive, what’s less obvious is why. What drives costs of living? Why, dollar for dollar, is an equivalent job worth more in Detroit than Dallas?

Costs of living are driven primarily by housing, food and transportation, all costs that are intensely local.

Demand Drives Cost of Living

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The most important thing to remember when it comes to cost of living is that the lion’s share of expenses cross only a few metrics. As measured by the Bureau of Labor Statistics, housing is by far the largest, occupying 30 to 42 percent of the average household budget. For city dwellers, that estimate hovers at around 40 percent of income.

Food eats another 15 percent, and transportation 15 more after that. These three categories alone account for the supermajority of an average household’s spending, but it’s important to remember exactly how variable these numbers can be. They can rise and fall, sometimes dramatically, based on your zip code.

To get a sense for that, a good place to start is Regional Price Parity.

The RPP is a statistic assembled by the Bureau of Economic Analysis. It measures price differences across states and cities expressed relative to a national baseline of 100 percent.  The state-by-state chart in Figure 2, drawn from this publication, shows just how widely prices can swing, taking a household budget along for the ride.

Figure2_RegionalPriceParity

Source: Bureau of Economic Analysis

For example while prices tumble in cities like Danville, IL (a mere 81 percent of the national average), in San Jose, CA they soar (goods and services cost 122.9 percent of the baseline).

The upshot of this variability is to render costs of living highly vulnerable to local pressures. At the same time as prices swing widely among different cities, the average budget is at the whim of just two or three large expenses. This means that households can’t smooth out aberrations across an entire spreadsheet. Where one outlying expense, like rent, could average out in a budget with a dozen equally important line-items, when the numbers are so dramatically weighted a single price fluctuation will dominate.

A Demand-Driven Balancing Act

“Housing is the biggest expense in terms of a household’s cost of living,” emphasized Diana Elliott, a Senior Research Associate with the Urban Institute. “[And] I think it’s important to keep in mind that affordability is based on the income that a household has as well as the rental costs.”

Costs of living, Elliott said, are experienced very widely. For someone living in the top income quintile rent will rarely occupy more than a quarter of the household budget (if even that). Expenses as a share of earnings are far lower and that share is far more disposable than it would be, say, for someone who earns less than $40,000 per year.

This has the effect of making certain communities far more affordable for some people than others, but it also has an enormous impact on how much landlords and stores can charge. Put simply, essentials are very responsive to supply and demand. (Put even more simply, landlords will often charge what people can pay.)

“Costs of living depend so much on what the residents themselves have in terms of income,” Elliott said.

“Take, for example, an area like San Francisco,” she said. “Many people look to San Francisco and point to rising housing prices. Certainly what you have there is this high demand from people with very high incomes, so you have a circumstance with people who are willing to pay more to live in the city.”

By contrast, she continued, compare Flint, Michigan. A low-income community, it’s high on the list of cities where renters pay a proportionately large amount of their income in rent. But objective prices are actually very low because they have adjusted to what the community can afford.

For an example of just how quickly this balance can shift look no further than North Dakota. In the wake of the state’s oil boom many communities saw the price of rent and food soar, as population and wealth suddenly expanded faster than the local infrastructure could keep up. Prices moved with the money.

The takeaway is not that rising incomes are a universal negative, but rather that income, infrastructure and costs of living are all set off against each other.

Finding the right community, financially, is about striking the balance between opportunity and expense. It’s why Jonesboro, AK with its RPP of 82 percent didn’t make Glassdoor’s recent analysis and Minneapolis, with its RPP of 102.6, did.

Prices might be higher in Minneapolis but so too are incomes, and that contrast is what determines how much take home pay workers keep.

Local costs of living are based on a balancing act. As long as a community can continue to grow the supply of housing, food and transportation at pace with its population’s spending power, things will remain relatively stable. It’s a delicate balance, however. If the population grows faster than the market can keep up, prices will rise in response to the reduced relative supply. Prices do the same in response to wealth as developers and retailers rush to capture the newly available dollars by producing higher-value commodities.

As Elliott pointed out, this can often leave low-income families in dire straits. When there’s a big-money market to capture low-income residents are the first ignored in favor of projects that have higher profit margins, such luxury condos and a Whole Foods.

It works both ways. As money and population evacuate a community costs of living fall. Rent is often particularly vulnerable to this; due to the long-term nature of building and operating a property the fixed costs of the rental market are far more variable than most other essentials. A landlord can show far more flexibility than, say, a grocer who has the bottom limit of how much that pound of potatoes cost to produce.

To crib the old saying, it takes a village to set the cost of living.