Input-Output Analysis

Input-output analysis is a type of economic analysis that is based on interdependent relationships between various economic industries or sectors in an economy. Individuals utilize this technique to estimate the effect of negative and positive shocks and analyze the ripple effects across an economy.

This economic model shows how a sector’s outputs flow into a different sector as outputs. It involves using input-output tables for the representation of various sectors’ supply chains within an economy. An economist named Wassily Leontief developed this model. There are three types of impact in the case of such an analysis. They are direct, indirect, and induced impacts.

• Input-output analysis refers to an analysis in macroeconomics that studies how various industries or sectors across an economy are interdependent. Economists conduct this analysis to predict the effect of positive and negative economic shocks.
• A vital benefit of such an analysis is that it helps determine the resource allocation for achieving the production level in the manufacturing or production program.
• In the case of this analysis, there are three types of impact — indirect, direct, and tertiary.
• A key feature of the input-output analysis is that it applies to equilibrium economies and economies having partial equilibrium.

Input-output analysis refers to a macroeconomic analysis method that involves observing the interdependencies existing between different sectors or industries throughout an economy. It offers a breakdown of every industry or sector with reference to their effects on the economy. Moreover, this model is crucial for a national economist because it helps analyze the economic shocks influenced by various industries and their ripple effects on the economy. Typically, a table or matrix presents the analysis.

The tables include various columns and rows of data quantifying the supply chain for every sector within an economy. The industries or sectors are listed in all the rows and column headers. The data in each column corresponds to the input levels utilized in that sector’s production function.

Some key features of input-output analysis are as follows:

• This type of analysis applies to economies with partial equilibrium and economic equilibrium.
• It is an empirical study-based analysis.
• The main purpose of this model is to consider and study the technical concerns associated with a product because it ignores demand analysis.

The policy advisers of the West and neo-classical economists do not commonly utilize this kind of analysis. That said, the concept has been used in Marxist economic analysis involving coordinated economies that depend on a central planner.

The three types of impacts in this type of analysis are as follows:

• Induced (Tertiary) Impact: This describes the increase in the personal consumption of services and goods owing to the suppliers’ workers.
• Direct Impact: This refers to the effect of an alteration in final demand on the directly associated inputs’ consumption.
• Indirect (Secondary Impact): This impact materializes because the directly associated input providers hire a workforce to fulfill the increased demand.

The total of the above three impacts combined with a change in the initial demand is an event’s total effect on an economy. Various studies carried out agree that the effects of the initial change in demand diminish owing to the leakage via spending and savings outside the domestic economy.

The assumptions of input-output analysis in economics are as follows:

• Economies are in perfect equilibrium.
• There is no production diseconomy or external economy.
• The production process occurs per the economic condition of constant returns to scale.  
• The entire economy has two divisions — the final demand and inter-industry sectors. In addition, each of these two sectors has further subdivisions.
• Every industry manufactures only a single product.
• Technological progress stays constant. Hence, input coefficients remain the same too.

Let us look at a few input-output analysis examples to understand the concept better.

Example #1

After Russia invaded Ukraine, energy prices surged 20% across the world for a duration of 5 months. The price of each barrel of WTI crude was $92.77 on February 24, 2022 was $92.77. However, between February 28 and August 3, it increased and averaged $106.96, up by 15.3%. Since energy utilization is entirely an intermediate output, the surging energy prices might have a small impact on real GDP or gross domestic product. Meanwhile, increasing energy prices can lead to a fall in social surplus, decelerating economic growth.

When energy prices increase, consumers primarily purchase less durable goods, such as new houses and cars. Moreover, the firms minimize their investment spending owing to uncertainty. Moreover, since fossil fuels are predominantly utilized as intermediate inputs upstream in a supply chain, higher global costs result from higher energy prices owing to spillover effects.

Experts favor an input-out analysis to study the spillover effects in the supply chain for this type of shock analysis. Specifically, they prefer the Leontief quantity model, a popular demand-driven model. That said, it has issues. This model is not consistent with supply analysis from a theoretical standpoint. Moreover, it is likely that it will overestimate the monetary damage as quantity and price are inelastic.  

Example #2

Suppose a local government wants to construct a new bridge and must justify the investment cost. It recruited Sam, an economist, to carry out an input-output analysis. The economist interacted with construction firms and engineers to predict the cost of the bridge, the total number of workers required, and the supplies necessary. Sam converted the details into dollars and ran numbers via an input-output model, producing three impact levels.

The direct effect is the original numbers put into that model, for instance, the raw inputs’ value. The direct impact refers to the jobs that supply companies (cement and steel organizations) generate. Such organizations must hire a workforce to complete the entire project. They may already have the required funds. Alternatively, they may borrow the money. This has another impact on the banks.

The induced impact refers to the money new workers spend on services and products for their families and themselves. This covers the basics, for example, clothing and food. However, since they now possess more disposable income, this is also associated with the products and services utilized for enjoyment.  

The impact-output model observes the ripple effects on the economy’s multiple sectors due to the local government building a new bridge. The government may need to bear specific costs for the bridge and utilize taxes. That said, the analysis will help understand the benefits generated by the project by recruiting companies that hire a workforce that spends in the economy, thus helping it expand.

Some benefits of input-output analysis in economics are as follows:

• This model involves analyzing the physical quantities manufactured and consumed in every industry, thus determining the allocation of resources for reaching the production levels in the production program.
• From input-output tables, manufacturers get to know the quantities and varieties of goods that they and other organizations can sell among themselves. This way, producers can make the required adjustments, improving their position in relation to the other producers.
• It can help estimate the direct requirements concerning labor, imports, and capital. Simultaneously, it can aid in estimating other sectors’ indirect requirements.
• One can find interrelations among different industries and firms regarding possible trends toward combinations from an input-output table.

Let us look at a few disadvantages of this type of analysis:

• The assumption that a product’s co-efficiency stays the same does not consider the potential to substitute factors. One must note that some potential for replacement is always there. Moreover, the replacement potential can be relatively high in the long run.
• This economic model is restricted and oversimplified, specifically focusing on the economy’s product side. Moreover, it does not explain why outputs and inputs follow a certain economic pattern.  
• The model can be difficult to understand as it involves a higher mathematics level.
• Assuming linear equations regarding a sector’s output and applicability in the other sectors is unrealistic.  

This has been a guide to what is Input-Output Analysis. Here, we explain it with its examples, assumptions, limitations, advantages, & types of impacts. You can learn more about it from the following articles –

• Economic Forecasting
• Wealth Maximization vs Profit Maximization
• Fault Tree Analysis