Input-output Analysis
Lecture notes by Atwijukire Rhinah
Input-output analysis ("I-O") is a form of macroeconomic analysis
based on the interdependencies between economic sectors or industries.
• This type of economic analysis was originally developed by Wassily
Leontief (1905– 1999), who later won the Nobel Memorial Prize in
Economic Sciences in 1973.
• This method is commonly used for estimating the impacts of positive
or negative economic shocks and analyzing the ripple effects
throughout an economy.
• The I-O model is important for production planning.
Three Types of Economic Impact
• I-O models estimate three types of impact: direct, indirect, and
induced.
• These terms are another way of referring to initial, secondary and
tertiary impacts that ripple throughout the economy when a change is
made to a given input level.
• By using I-O models, economists can estimate the change in output
across industries due to a change in inputs in one or more specific
industries.
The direct impact of an economic shock is an initial change in
expenditures. For example, building a bridge would require spending
on cement, steel, construction equipment, labor, and other inputs.
The indirect, or secondary, impact would be due to the suppliers of
the inputs hiring workers to meet demand.
The induced, or tertiary, impact would result from the workers of
suppliers purchasing more goods and services. This analysis can also
be run in reverse, seeing what effects on inputs were likely the cause
of observed changes in outputs.
• An Example of how I-O analysis works: A local government wants to build
a new hospital and needs to justify the cost of the investment.
• To do so, it hires an economist to conduct an I-O study. The economist
talks to engineers and construction companies to estimate how much the
project will cost, the supplies needed, and how many workers will be hired
by the construction company. The economist converts this information into
shillings and runs numbers through an I-O model, which produces the three
levels of impacts.
The direct impact is simply the original numbers put into the model, for
example, the value of the raw inputs (cement, steel, etc.).
The indirect impact is the jobs created by the supplying companies, so
cement and steel companies.
The induced impact is the amount of money that the new workers spend on
goods and services.
Assumptions of I-O model:
• It assumes that there are n interlinked industries
• Assumes that each industry produces one single good.
• Assumes that each industry uses a fixed-proportion technological
process
Example
Lets assume that we produce glass in Our output that can be sold
directly to consumers (e.g. to home-owners), or can be used as an input
for other industries (e.g cars)
We can use inputs from other industries to produce our good (e.g. labour
and machinery)
So there is interindustry dependence.
• Suppose we divide the economy into 3 sectors:
1. Agriculture
2. Manufacturing
3. Services
The three industries each use inputs from two sources:
Domestically produced commodities from the three industries
Other inputs, such as imports, labour, and capital.
The outputs of the industries have two broad uses or destinations:
Inputs to production of the three industries (intermediate inputs)
Final demand (Consumption, Investment, Government expenditure, Exports)
We can define the following two vectors
