Modeling Input-output Impacts with Substitutions in the Household Sector: a Numerical Example

Although there have been many elaborations of the basic input-output approach, including multi-regional models, dynamic models, models with variable coefficients, supply-side models, etc., these approaches all have the same limitation. The fixed-coefficients production function assumptions ignore substitutions in response to price changes that can be expected to accompany most shocks– skipping over the heart and soul of market economics. This research note suggests a simple approach to estimating new technical coefficients matrices after a shock so that short-term substitution effects can be studied. Given a reduction in income (as reflected in the value added row), households are likely to make substitutions, reducing their final demand by less than the application of the base-year I-O coefficients would indicate. If this can be observed, the application of RAS procedures can generate an appropriately modified A matrix. Due to some well known limits in applying the traditional RAS approach, we reformatted it and suggest a new economic model that can link coefficient adjustments to degrees of a priori substitutability and complementarity. Based on this resolution, we look forward to detailed studies of specific coefficients and how they evolve over the short term. JEL Classification: C67, D57, R19