Input-output models and increasing economic output

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This blog explores a variety of economic concepts, particularly how SPICe use input-output models. It provides an example of the type of research questions we answer for MSPs. The content of this blog is more technical in nature than some of our previous SPICe blogs.  Thus, to help with understanding we’ve included lots of links to explanations of terms.

What’s an input-output model?

An input–output (IO) model is a quantitative economic model that represents the interdependencies between different sectors of a national economy. It is essentially a simplified framework used for describing the workings of the economy. The model depicts inter-industry relationships within an economy, showing how output from one industrial sector may become an input to another industrial sector. It also acts as a statistical and analytical tool for producing reliable national accounts and for economic impact analysis at a national level. The input-output analytical tables are derived from supply and use tables.

The supply and use tables provide the main macroeconomic aggregates such as GDP, components of value added and output by industry, import, final consumption, gross capital formation and exports. One of the main uses of input–output analysis is to measure the economic impact of public investments, projects and events, and policy interventions by the public sector. It can also be used to refine policy activities by identifying economically related industry clusters and targeting industries to enhance the internal coherence of an economy.

IO models can be linked to other datasets to create extensions. For example, the Scottish Government IO model has an environmental extension that makes it possible to estimate Greenhouse Gas Emission effects.

It should be cautioned that figures from economic models, such as IO models, are often presented as fact. However, this is inaccurate given the level of assumptions that feed into models. Any modelling results should be interpreted as estimates and only be used to give a broad indication of possible economic trajectory, rather than a precise estimation of economic impact.

Scotland’s input-output model

The Scottish Government produce and publish Input-Output Tables (IO tables) for Scotland. The most recent tables were published in July 2019 for the year 2016. Tables are available to download from 1998 onwards. The Scottish Government’s IO website provides detailed guidance on:

Scotland’s IO tables provide a complete picture of the flows of products (goods and services) in the economy for a given year. They detail the relationship between producers and consumers and the interdependencies of industries. These interdependencies are shown for each industry and cover the direct and indirect (categorised as type 1) and direct, indirect and induced (categorised as type II) effects upon total output of an additional £1m of final demand (these concepts are explained further below) The range of economic impacts that can be calculated include: output multipliers, income effects and multipliers, employment effects and multipliers, GVA effects and multipliers.

Where should the government target spending to grow the economy?

In SPICe we sometimes get research questions about IO models to estimate the economic impact of additional spend in a specific sector or more generally what sectors public investment spend should be targeted at to increase economic output and grow the economy. For this type of query, we would look to the output multipliers within the Scottish IO tables, specifically the Type II output multiplier.

The Type II output multiplier for an industry is expressed as the ratio of direct, indirect and induced output changes to the direct output change due to a unit increase in final use.

SPICe_2019_Blog_Input Output models_Type II multiplier

Some adjustments for imports need to be made before applying the multiplier to any spend figures. Although supply chain import leakage (money that exits the Scottish economy system rather than remaining within it) is accounted for in the Input-Output model, the final demand (consumer) spending that the multipliers are applied to should not include spending on imported products. Within the IO tables, it is possible to calculate the proportion of imports in the supply chain by sector. These import estimates are then used to adjust spend prior to applying the multiplier.

The below table shows the top 20 sectors in the Scottish economy in terms of additional output return for every £ spent. Prior to applying the output multiplier adjustments were made for imports to the spend figure as outlined above. Electricity has the highest economic output return. For example, for every £1,000,000 spent (direct effect) in the electricity sector, another £815,000 of output (indirect & induced) is supported in the rest of Scotland’s economy. Full data for all sectors in the Scottish economy is available from the link below the table.

Top 20 sectors for additional output for every £1,000,000 spent

SPICe_2019_Blog_Input Output models_TableSource: SPICe analysis of Scottish Government Input-Output Tables (published July 2019) Full data for all sectors can be accessed from IO data analysis

The types of industries that rank highly in terms of generating additional economic output tend to be those that use more indigenous raw materials and comparatively smaller proportions of imports in the supply chain. Industries that use a high proportion of inputs from elsewhere in the Scottish economy, create more positive knock-on effects.

It’s not so straightforward – there are constraints

However, at this stage in the process it should be stressed that increasing economic output, is not as straightforward as skewing spend towards the sectors with the highest output return. This is due to numerous factors such as capacity, scarcity of resources, regional variations, etc.

For example, forestry harvesting in the above table has a high additional return of £814,000 in the rest of the economy for every £1,000,000 spent. However, forestry and land are finite resources. Thus, the economy only has a limited amount of capacity to expand a sector of this nature.

Consequently, when making any policy or spending decisions, it’s important to consider would there be spare capacity within the economy to supply. And if there isn’t capacity that prices would likely increase, resulting in the new demand being satisfied with imported products, therefore bypassing Scottish supply chains altogether. Also  consideration should be given to possible negative environmental/climate effects of focusing spend at a specific sector.

Furthermore, the IO model is a static snapshot of the Scottish economy for a specific year. Static models are not the best for estimating theoretical, large scale changes to the structure of the economy. For these types of questions dynamic price change models such as Computable General Equilibrium models, themselves an extension of the IO tables, would be more suitable,

Generally, it isn’t advisable to use output multipliers to identify sectors for investment to increase economic output given these caveats. In terms of other options to increase economic output, limiting imports in the supply chain has a similar impact, although would likely have EU rule implications at present. Thus, policy options could include considering import leakage within the domestic supply chain and developing options around supporting and/or expanding specific industries along that chain within the domestic economy in order to reduce the need for imports. The above table gives an indication of the scale of imports used in each sector’s supply chain.

Feature image “1000 Color Radial” by sjrankin is licensed under CC BY-NC 2.0 

Alison O’Connor, Senior Analyst, Financial Scrutiny Unit