Wage Differentials across Labor Markets and Workers: Does Cost of Living Matter?

By Dumond, J. Michael; Hirsch, Barry T. et al. | Economic Inquiry, October 1999 | Go to article overview

Wage Differentials across Labor Markets and Workers: Does Cost of Living Matter?


Dumond, J. Michael, Hirsch, Barry T., MacPherson, David A., Economic Inquiry


I. INTRODUCTION

An implication from economic theory is that utility gained from labor services should tend toward equality across competitive labor markets among similar workers. Many studies have examined the dispersion in wage rates across areas in order to shed light on the competitive hypothesis (for a review, see Dickie and Gerking [1989]). Such studies provide little support for the hypothesis of wage equalization, although analysis is often constrained by limited information on area prices, amenities, and individuals across a large number of labor markets. Even following control for measurable worker and area characteristics, there exists considerable dispersion in wages across markets. Moreover, interarea differentials are not reduced following full adjustment for measured cost of living (e.g., Johnson [1983]).

Independent of this line of inquiry, the empirical literature in labor economics abounds with regression estimates of wage differentials by, among other things, region, city size, race, gender, public/private status, part-time status, union status, schooling, marital status, and industry. Because of a lack of information about cost of living, standard wage differential estimates are based on nominal (i.e., price-unadjusted) rather than price-adjusted wages. The relationship between cost of living and wage differentials based on individual or labor market characteristics, therefore, is not widely known.

Even were interarea worker, price, and amenity data readily available, it is far from clear how such data should be used. Studies that control for cost of living generally assume (implicitly or explicitly) that measured differences in prices reflect true differences in acquiring utility across markets. Yet differences in cost of living in part reflect the valuation placed on land and other goods and services owing to site-specific amenities valued by consumers or businesses (see, among others, Roback [1982, 1988]; Beeson and Eberts [1989]). Differences in area wages that are fully adjusted for measured cost of living might accurately reflect utility differences if none of the price variation reflected household valuation of area amenities (i.e., if all price differences reflected cost differences in acquiring utility). Nominal wage differentials (i.e., wages unadjusted for prices) might accurately measure utility differences if all variation in prices reflected workers' valuation of area amenities. Neither assumption is likely to be correct. Moreover, heterogeneity in tastes makes real wage comparisons problematic, since workers and businesses tend to sort into markets with relative prices and amenities most in line with their preferences or cost structure.

Our article explores two principal lines of inquiry. First, we examine differences in estimated wage differentials among regions, by city size, and across labor markets, measured alternatively by nominal wages, wages fully adjusted for measured cost of living, and by a partial adjustment method that may better approximate a real wage. Evidence here allows us to address the competitive hypothesis of wage equalization, as well as to assess alternative methods for dealing with interarea price differences. To conduct this analysis, we assemble cost of living information for 185 metropolitan areas (comprising 69.8% of our Current Population Survey (CPS) sample across the entire U.S.) based on 1985-95 survey data from the cost of living index gathered by the American Chamber of Commerce Researchers Association (ACCRA). The ACCRA price data are in turn matched to data on individual workers from the Current Population Survey Outgoing Rotation Group (CPS-ORG) monthly earnings files for October 1985 through May 1995 and to data on area amenities.

The second line of inquiry focuses on estimation of wage differentials by race, gender, union status, part-time status, private/public status, and industry. Here we examine the sensitivity of nominal, full adjustment, and partial adjustment wage differential estimates to the presence of controls for detailed city size. …

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