The Roback Model

Compensating Differentials

• Rosen (1974) has a famous paper in which he argues that price differences must
compensate for quality differences in labor and product markets in equilibrium

• This is the idea of “compensating differentials”

• If observe two workers with the same skill making different wages at
different jobs, the wage gap must reflect the differences in the non-pecuniary
benefits of the jobs

• If not, the worker with the job that had the lower wage+benefit would
move to the other job

• If we observe the same product sold at two different prices, it must be that
the higher priced product is of higher quality, otherwise nobody would buy it
and its price would be bid down

• Roback (1982) extended these ideas to analyze implications for linkages between
local housing and labor markets
 Main Ideas of the Roback Model

• Consumers must have the same utility at all locations

• This means that local consumer amenity differences are compensated for by
some combination of wage and cost of living (real estate price) differences
across locations

• Higher amenity places must have lower wages and/or higher cost of living
• These local consumer amenities can include weather, view, nightlife,
quality of local government services, etc.

• Firms must have the same profit at all locations

• This means that local productive amenity differences are compensated for
by some combination of wage and cost of local input (real estate price)
differences across locations

• More productive places must have higher input costs

• The same factors that affect consumer amenities can also influence firm
productivity
 Consumers
Being indifferent across locations means that utility is the same everywhere:
U(c,q,a) equalized across locations
c = non-housing (traded good) consumption of price 1
q = housing (nontraded good) consumption of local price p
a = local amenity

y = c + pq => income = wages = non-housing cost + housing cost

So
U(y-pq,q,a) is equalized across locations. People are going to choose the amount of
housing in each location that is right for them. That is, there is some q*(y,p,a) that is
chosen. Therefore, we can rewrite this as
U(y-pq*(y,p,a),q*(y,p,a),a) = V(y,p,a) = u

If price and income differences are small across locations, it turns out that we can
use calculus on the above equation to derive:

(%diff in a) = (share of expenditure on housing)(%diff in p) - (%diff in y)

Where this percent difference is across locations. Therefore, we can actually back
out the relative amenity value of locations experienced by the average consumer
with data on each element on the right of this equation.
 Consumer Equilibrium in the Roback Model
The equilibrium condition is:

(%diff in a) = (share of expenditure on housing)(%diff in p) - (%diff in y)

Replace “%diff” by dln and (share of expenditure on housing) by Sh. Rearranging, we

get
1 1
d ln p = d ln y + d ln a (M1)
Sh Sh
Where these percent differences (expressed as dln) are across locations. Sh is about
0.25 in the data, meaning coefficients in the equation above are about 4.

• If wages are taxed at a federal rate t=0.36 and only a fraction Sw = 0.6 of income
is from wages, then this relationship becomes

(%diff in a) = (share of expenditure on housing)(%diff in p)

– (1-marginal tax rate)*(share of income from labor)*(%diff in y)
(1 − t ) S w 1
Rearranging, we now get d ln p = d ln y + d ln a (M2)
Sh Sh
= 1.53 =4
 Implied Indifference Curves for V(y,p,a) = u
high amenity medium amenity
ln p locations locations

low amenity
locations

ln y
• Empirical Evidence on
Amenities/QOL from
Albouy (2012)

• Cities above a line have

higher than average QOL,
below a line lower than
average QOL
• Equation (M1) in the prior
slide is the dashed blue line

• The solid line is additionally

adjusted for differences in
federal tax burden, the
share of income from
wages, and the fact that
other local prices vary with
housing cost
• In particular, it uses
Equation (M2) in the prior
slide
• Analogous Evidence for
Canada (Albouy, 2013)

• Note a flatter average

mobility condition in
Canada than the US
 Firms

Profit = Af(L,K,R) – yL – rK – pR must be equalized across locations

L = labor hired at wage y
K = capital hired at national rental rate r
R = local inputs (real estate) used at local price p
A = local productive amenity (constant returns to scale assumed)

Each firm will choose an optimal amount of L, K and R conditional on location

The result are the factor demands L*(y,r,p), K*(y,r,p) and R*(y,r,p)

Therefore, we can say that “indirect profits” are equalized across locations:
P*(y,r,p,A) = p

With some calculus, it is possible to show that if differences in p and y across

locations are small,
(%diff in A) = (share of firm costs spent on labor)(%diff in y)
+ (share of firm costs spent on non-labor locally provided inputs)(%diff in p)

Therefore, we can back out the relative productive amenity value of locations
experienced by the average firm with data on each element on the right of this
equation.
 Firm Equilibrium in the Roback Model

• The equilibrium condition for firms is

(%diff in A) = (share of expenditure on labor)(%diff in y)

+ (share of expenditure on local inputs)(%diff in p)
N 1
Or d ln p = − d ln y + d ln A
L L
 N = 0.7, L = 0.095

and − N = −7.37
L

• We can derive this exact same condition by starting with a condition that unit
costs must be equalized across locations: If productivity is higher, costs are lower.
 Implied Indifference and Iso-Profit Curves
high consumer
ln p amenity locations medium consumer
amenity locations
low consumer
amenity locations

high producer
amenity locations
medium producer
amenity locations
low producer
amenity locations
ln y
• Empirical Evidence on
local productive
amenities from
Albouy (2012)

• Cities to the right of

the dashed red line
have higher than
average A, to the left
of the dashed red line
have lower than
average A

• San Francisco is
awesome!
• Reminder on Analogous
Evidence for Canada
(Albouy, 2013)

• Almost identical avg 0

profit condition to the US
• Implied relative
productivity and quality of
life for Canadian cities and
provinces