By Harry Ferdon, Economist
What Is a Multiplier Analysis and Why Is It Needed?
When thinking about the full economic impact of an external factor, such as a new regulation or devastating weather event, businesses, investors, and regulatory agencies often want to understand what the total cost is in terms of lost revenue for businesses across the industry, as well as jobs, income, and taxes losses across all affected communities. Similarly, when a new capital project is breaking ground, it is often presented with broader economic benefits in terms of increased economic activity and jobs in the regional economy. Quantifying these total impacts is possible using an economic tool called a multiplier analysis.
Direct, Indirect, and Induced Impacts
Anytime there is a direct economic impact, such as when farmers are impacted by drought, it creates ripple effects through the entire economy, beyond just the revenue lost by those directly impacted businesses. Directly impacted businesses going out of production means inputs will no longer be purchased, thus resulting in less business-to-business spending. In addition to the revenue lost by the directly impacted businesses, additional revenue is lost by businesses who cater to the directly impacted businesses. These are the indirect effects of the direct impact. This also results in a loss of income for employees of the directly impacted businesses, as well as for employees of indirectly impacted businesses, i.e., those who saw a reduction in revenue due to less input purchases. This decrease in income may result in less household, recreation, and other spending across the economy. These are known as the induced effects. Along with losses in revenue and income, overall employment in the affected region will decrease, as will local, state, and federal tax revenue.
Multiplier Analysis: Quantifying the Impacts
There are different ways to carry out an analysis to quantify these effects. The most straightforward method is using what’s called a multiplier analysis. Multipliers are coefficients established for different industries and regions capturing the relationship between direct changes and changes to other industries across the economy. Multipliers are derived from an input-output (I-O) model, such as that used by the U.S. Bureau of Economic Analysis (BEA). Input-output models use data on industry purchases and matrix algebra to approximate the relationship between the various sectors of an economy. Based on these individual relationships, data are aggregated to establish multipliers capturing broader impacts to the whole regional economy. For example, if an industry in a given region has a total effects multiplier of 2.1, then a direct increase of $1 million in revenue would result in a total economic impact (sum of direct, indirect, and induced impacts) of $2.1 million.
A more comprehensive economic impact analysis can analyze the specific ripple effects throughout a regional economy. This type of analysis takes industry multipliers to summarize a direct impact’s resulting indirect and induced impacts on output, value added, employment numbers, employee and owner income, and taxes. Additionally, impacts to specific industries in the economy can be separated out. This type of comprehensive economic impact analysis is generally run using a specific input-output software package. These analyses can also be customized to study the impacts on specific, niche industries outside of the generic sectors with available data.
A standard multiplier analysis has several shortcomings. First, it is necessary to quantify the direct economic impact and this is done outside of any multiplier model. Second, multipliers only consider effects in “backward-linked” industries which are businesses that sell inputs to the directly affected industry. In agriculture these forward-linkages to processing, shipping, and ultimately consumer retail are critically important and we specialize in developing customized models to evaluate such changes. Third, multiplier models have very coarse industry segments. In many cases these aggregate multipliers are not applicable for California’s specialty crop industries. We also specialize in developing customized analyses to quantify impacts tailored to conditions in California and western specialty crop sectors.
Multiplier Analysis: Applications
ERA has run a multiplier analysis and/or comprehensive economic impact analysis for a variety of projects. Analyzing the potential economic impacts of a new regulation is a requirement of the California rulemaking process for agencies, and often is of interest to other stakeholders as well.
A related type of analysis that also uses multiplier models is called a contribution analysis. This type of analysis establishes the jobs, income, value added, and economic activity created by a specific industry in a specific region. For example, we have worked with our clients to quantify the contribution of specialty crop agriculture in different parts of California.
ERA will use a multiplier model combined with a market effects analysis to conduct a comprehensive total impact analysis of a new regulation. Multiplier analysis can be a useful tool when appropriately applied to quantify how changes can become larger and affect other sectors of the economy.
If you’re interested to talk more about a multiplier analysis, please contact Harry Ferdon.