Why is the ‘Cost of Living’ in Cities So High?

John Cochrane has an entertaining and informative blog called “The Grumpy Economist,” offering insights centered in the Chicago School approach that nonetheless will resonate with the Austrian reader. However, in a recent post Cochrane erroneously claimed that people living in high-rent areas of California were effectively using a different currency than other Americans. This type of loose talk is incorrect, as Mises explained in his classic 1912 work, The Theory of Money and Credit. In this article I’ll pinpoint the precise error involved, to shed light on how prices and wages are set in the market economy.

Cochrane on Price Indices

The main subject of Cochrane’s post concerns the estimation of “price indices” and the measured rate of (consumer price) inflation. But in the present article I want to focus on this portion of Cochrane’s commentary:

The next issue…that I think is much under-studied: the huge local variation in prices, and, via huge variation in what we consume, the inflation experienced by people in different parts of the country. Living in California and especially the Bay Area is like living in a different country with a different currency. Even gas costs twice what it does in the rest of the country. A lot of what appears to be income inequality is just different prices, and especially land prices. (Much of the productivity of tech workers went in to the pockets of existing land owners.) If you get paid 100 yen in Japan, you’re not 100 times wealthier than someone who gets paid 1 dollar in the US. Being paid $100,000 per year in San Francisco is something like that—and being paid $20 per hour in much of the US is nowhere near the disaster [that] being paid that much in San Francisco would be.

Although Cochrane is putting his finger on an important point regarding estimates of income inequality, his motivation is totally wrong. Yes, if Smith makes $100,000 working in San Francisco while Jones makes $50,000 working in Cleveland, it would be wrong to conclude that Smith necessarily is enjoying “twice the standard of living” as Jones.

However, Cochrane is wrong to argue that this phenomenon is akin to different currencies being employed in the two regions. For one thing, we know that it’s U.S. dollars being used in both places. (Duh.) But more important, the fact that most prices are higher in San Francisco doesn’t mean that dollars-in-San-Fran are weaker than dollars-in-Cleveland, the way we can say that the yen is weaker than the dollar.

Mises on the “Cost of Living” and the Purchasing Power of Money

Mises addressed the fallacy underlying Cochrane’s argument, but also the germ of truth in Cochrane’s position, in his classic 1912 work, The Theory of Money and Credit:

[T]hat the cost of living is different in different localities only means that the same individual cannot secure the same degree of satisfaction from the same stock of goods in different places….[T]he belief in local differences in the cost of living is…supported by reference to local differences in the purchasing power of money….It is no more appropriate to speak of a difference between the purchasing power of money in Germany and in Austria than it would be justifiable to conclude from differences between the prices charged by hotels on the peaks and in the valleys of the Alps that the objective exchange-value of money is different in the two situations and to formulate some such proposition as that the purchasing power of money varies inversely with the height above sea-level. The purchasing power of money is the same everywhere; only the commodities offered are not the same. They differ in a quality that is economically significant—the position in space of the place at which they are ready for consumption.

But although the exchange-ratios between money and economic goods of completely similar constitution in all parts of a unitary market area in which the same sort of money is employed are at any time equal to one another, and all apparent exceptions can be traced back to differences in the spatial quality of the commodities, it is nevertheless true that price-differentials evoked by the difference in position (and hence in economic quality) of the commodities may under certain circumstances constitute a subjective justification of the assertion that there are differences in the cost of living. [Mises, The Theory of Money and Credit, p. 176, emphasis in original.]

To drive home the point, Mises then applies these principles to the case of Karlsbad, which (in his day) was an attractive tourist destination because of its spa:

He who voluntarily visits Karlsbad on account of his health would be wrong in deducing from the higher price of houses and food there that it is impossible to get as much enjoyment from a given sum of money in Karlsbad as elsewhere and that consequently living is dearer there. This conclusion does not allow for the difference in quality of the commodities whose prices are being compared. It is just because of this difference in quality, just because it has a certain value for him, that the visitor comes to Karlsbad. If he has to pay more in Karlsbad for the same quantity of satisfactions, this is due to the fact that in paying for them he is also paying the price of being able to enjoy them in the immediate neighborhood of the medicinal springs. The case is different for the businessman and laborer and official who are merely tied to Karlsbad by their occupations. The propinquity of the waters has no significance for the satisfaction of their wants, and so their having to pay extra on account of it for every good and service that they buy will, since they obtain no additional satisfaction from it, appear to them as a reduction of the possibilities of the enjoyment that they might otherwise have. If they compare their standard of living with that which they could achieve with the same expenditure in a neighboring town, they will arrive at the conclusion that living is really dearer at the spa than elsewhere. They will then only transfer their activity to the dearer spa if they believe that they will be able to secure there a sufficiently higher money-income to enable them to achieve the same standard of living as elsewhere. But in comparing the standards of satisfaction attainable they will leave out of account the advantage of being able to satisfy their wants in the spa itself because this circumstance has no value in their eyes. Every kind of wage will therefore, under the assumption of complete mobility, be higher in the spa than in other, cheaper, places. [Mises, The Theory of Money and Credit, pp. 176-177]

As Mises makes clear, when the “cost of living” is relatively high in a certain area, it’s because there is something that attracts people. The higher density of the population drives up the price of land, which means rental prices are higher. This is the market economy’s way of rationing the scarce good “proximity to the region that many people like” and allocating it to those most willing to pay for it.

Cochrane’s Mistake: Extending the Analysis

Thus far, it might seem as if I’m quibbling over semantics, because Mises seems to agree with the spirit of Cochrane’s observations. However, the important difference—and the basis for my article—is that Cochrane thought the higher “cost of living” was akin to people in San Francisco using a different currency. And as Mises stresses repeatedly in the passages I quoted above, that is simply not correct. Not only do people in San Fran and Cleveland both use dollars, but the dollar has the same purchasing power in both places, as well.

If it didn’t—in other words, if it really were the case that you could buy more of “the same goods” with $100 in Cleveland than you could in San Francisco—then why wouldn’t merchants buy goods for $100 in Cleveland and sell them for (say) $140 in San Francisco, netting a profit after the costs of transportation were taken into account?

Once we think through the logic of arbitrage, we see that Cochrane’s throwaway remark about people in the Bay Area using a “different currency” is untenable. People in the Bay Area use the same dollars as everywhere else in America. The reason prices are higher in the Bay Area has to do with taxes and higher real estate prices.

For example, according to AAA, gas prices in California as of this writing average $3.61 per gallon, while in neighboring Nevada they’re only $3.12. This seems like an odd discrepancy; why don’t some enterprising fellows load up tanker trucks in Reno, and drive the 200+ miles to San Francisco, to make about 50 cents per gallon delivered (before subtracting their costs of transport)?

The main reasons are that California has special environmental regulations on the gasoline that can be sold in the state, even requiring different summer/winter blends. This means refiners have to create gasoline specifically for the California market. Further, California enacts higher taxes on gasoline than its neighbors—in fact, the highest in the country—as this chart from the American Petroleum Institute (API) reveals:

As the chart indicates, the state and local gas tax average in California is some 27 cents higher per gallon than in Nevada—and a whopping 42 cents per gallon higher than in Arizona.

Obviously John Cochrane, a professional economist who taught at (the Booth School of Business at) Chicago University, understands the role of taxes in affecting retail prices. But nonetheless, it is a category mistake to say this disparity in prices is comparable to the use of different currencies. Cigarettes cost way more in New York City because of the whopping taxes levied on them; it’s not because New Yorkers use a different type of money.

Why Do People Pay More to Live in Big Cities?

Another way to see the flaw in Cochrane’s analogy is to ask: How are these discrepancies supported? For example, if Firm A in Cleveland offers pay of $50,000 per year, while Firm B in Cleveland offers pay of 5 million pennies per year, then that’s actually the same salary. The monetary unit in the first firm is dollars, while in the second it’s pennies, and the exchange rate between the two is one dollar trades for 100 pennies.

But that’s clearly not what’s going on, when Firm A in Cleveland pays $50,000 per year for “the same job” that pays $100,000 in San Francisco. If workers in either city saved up $10,000 from their respective paychecks and wired them to their mothers back home (in Florida, say), then they would be the same money. It’s obviously not true that “dollars earned in San Francisco” are a different currency from “dollars earned in Cleveland,” the way it really would be a different unit if a firm paid its workers in pennies (or Japanese yen).

This raises the question, then, of why do workers move to a big city where the rent is so high? As I’ve exhaustively argued above, this isn’t a mere matter of units. Dollars are the same in San Francisco, but most of the prices are higher. Why do people put up with this?

The obvious answer is, “Because wages and salaries tend to be higher.” But why don’t we see, for example, millions of people living in Antarctica? It would be really expensive to build adequate shelter and food delivery in such an environment, and so in order to get people to move there, the wages of janitors in Antarctica would have to be astronomical. Yet we don’t see this; the market outcome is that barely anybody lives in Antarctica.

The brief explanation is that the productivity of many types of labor is much higher in urban areas than elsewhere. Historically the development of the big cities in the United States was tied to water transport: New York, Los Angeles, and Houston are still major port cities, while Chicago’s access to the Great Lakes and key rivers played an important role in its growth.

So it wasn’t a coincidence that America’s largest cities developed where they did. However, once people start living in close proximity because of some external factor (such as access to the water), there is a separate effect: Their productivity is amplified in other areas too, simply because of their proximity. The “economic approach to cities” is an entire subfield, so I won’t dwell on it here. Suffice it to say, people don’t spread out uniformly across the land, the way electrons repel each other on the surface of an object to distribute the electric charge uniformly.

Rather, more than half of the people in the world currently live in urban areas or cities, with projections that that figure will rise to two-thirds by 2050. There must be some reason for this attraction. On the consumer side, it might be the ability to eat at the finest restaurants and go to a Broadway show (if we’re talking about Manhattan). On the producer side, it might be because cities offer the highest salaries, and are worth moving to, despite the higher price for an apartment of a certain size.

Yet contrary to Cochrane, these high wages aren’t due to a difference in currency; they are supported by the fact that the productivity of workers is genuinely higher. The worker who is paid $100,000 in San Francisco is producing twice as much for his employer as the worker who is paid $50,000 in Cleveland. This isn’t because the units are different, it’s because the first worker is genuinely more productive.

Conclusion

John Cochrane’s remark that living in the Bay Area is “like living in a different country with a different currency” is innocuous enough for everyday conversation, and it also does bring nuance to the debates over income inequality in the United States. However, strictly speaking, his claim is economically nonsense. Moreover, when we think through exactly what’s wrong with it, we end up appreciating the intricacies of the market economy and the role prices serve in allocating resources, including labor.