Price Level Adjustments Challenge Assumptions about US Regional Standards of Living

It is widely believed that labor productivity and the material standard of living in the southern US trail those of the rest of the country. Analyses support this view [ILLUSTRATION FOR EXHIBIT 1 OMITTED], though it is hypothesized that eventually the regions within the US will converge.(*) But such analyses, based on standard economic data and methodology, fail to take into account varying regional price levels.(**) When adjusted for these, the picture looks very different: not only does the gap between standards of living and levels of labor productivity in different US regions shrink, but the order of rank changes. The south, it seems, is better off than either seaboard. When the output and productivity of different countries are being compared, price-level adjustments, rather than exchange rate conversions, are normally used. Productivity comparisons are based on physical value added (physical output minus material inputs). However, a simple exchange rate conversion of the production figures will not reflect the physical quantity of output in each country. For the number of francs you would pay for a Big Mac in Switzerland, for example, you could have two Big Macs in the US after conversion to dollars, or four Big Macs in China after conversion to yuan.(***) In other words, exchange rate conversions fail to reflect the fact that the purchase price of the same quantity of goods varies from country to country. To make valid comparisons about productivity, therefore, purchasing power adjustments have to be made to gross product figures. How the adjustment factor is calculated depends on what is being adjusted. For a single item, such as a Big Mac, one simply compares the prices of the same item in each country. When comparing entire economies, a "basket of goods" representative of the economy as a whole is used. This adjustment factor is called a purchasing power parity (PPP). PPPs can be used to show price differences between US regions just as they are used with countries. The prices of an illustrative sample of 15 of the 59 goods covered by the American Chamber of Commerce Researchers Association (ACCRA) for its Cost of Living Index suggest there are significant variations within the US in the purchase price of like goods, even though there is a common currency [ILLUSTRATION FOR EXHIBIT 2 OMITTED].(*) The price of a Big Mac in midtown Manhattan, for example, is one and a half times the price of a Big Mac in downtown Atlanta. Applying these PPPs to standard-of-living and labor productivity figures reduces the gaps between regions and changes the regions' rank. Exhibits 3 and 4 show the price-adjusted figures and the new rankings. (The range of figures takes account of the inherent errors in the data. For an explanation of this, see the boxed insert, "Methodology and issues.") Given the range of figures, the findings point to two possible hypotheses. One is that convergence between regions in terms of material standard of living and labor productivity has already largely occurred. This hypothesis makes sense, because two important factors have an equalizing influence. The first is that all regions operate within the same macroeconomic environment: the US Federal Reserve Bank sets interest rate and monetary policy for the whole nation, so a bank on the west coast charges similar interest rates to a bank in the south. The second is that there are few regulatory or trade barriers between regions, so while, for example, a relatively flexible job market allows workers to move in search of a higher standard of living, this standard of living comes down if an influx of new people arrives to push up prices by raising demand. The same effect occurs if investors are attracted to lower-wage regions. In leaving their traditional manufacturing area around the Great Lakes to take advantage of relatively low wages and abundant labor in the south, automobile manufacturers, for example, have increased labor productivity in the south, and hence the standard of living. …