Business Mathematics

Lecture 5
Input-Output Analysis
Lecturer: Kahenya, N.P

Introduction to Lecture 5
This lecture introduces you to input-output analysis in economics and business-related problems.
It is a continuation of lecture 4 on matrix algebra on application of matrices.

Further Readings
These notes have been derived from diverse resources. These resources are recommended for
further reading to gain more insights on the application of matrix algebra and input-output
analysis to economics, and other areas. The resources offer a detailed background to not only
matrix algebra but also an introduction to input-output analysis that may not be covered in this
lecture. These are (Jacques, 2006; Lay et al., 2016; Werner & Sotskov, 2006).

Intended Learning Outcomes

At the end of this lecture, you will be able to;

(i) Define terms used in input-output analysis.

(ii) Apply the Leontief input-output model.

Introduction
Input-output analysis is an economic model that is used to study interdependencies between
different sectors of an economy. This model was developed by Wassily Leontief in the 1950s. It
is a popular model in economics, planning, and policy analysis. The model recognizes that the
economy is represented as a system of interconnected sectors. Each sector produces/supplies
goods and services i.e. their outputs, using input from other sectors. Hence the model’s interest
is to understand how changes in one sector influences other sectors and by extension the overall
economy of a country.

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Terms Used in Input-Output Analysis
Let us assume that a country’s economy is divided into 𝑛 sectors that produces goods or services
(outputs). Suppose x is the production vector in ℝn that represents the output of each sector of
a given period.

Again, suppose that there exists another sector of the economy that only consumes goods and
services i.e. the open sector. Let vector d be a final demand vector that list the value of goods
and services demanded by the open sector such as the consumer demand, government
consumption, surplus production, export etc.

Note that as the ‘various sectors produce goods and services to meet consumer demand, the
producers create additional intermediate demand for goods and services they need as inputs for
their own production’(Lay, 2003).

THE LEONTIEF MODEL (Lay, 2003)

𝐱 C𝐱 𝐝
= +
Amount Produced Intermediate demand Final demand

The intermediate demand plus final demand consists of the total output.

Total value of input is the amount of goods and services used in the production of other goods and
services.

The input of an industry that originates from non-producing sectors such as labor, imports etc is
referred to as the primary input.

In a closed input-output model, the entire production is consumed only by the productive industries
in the economy. This model favors the intermediate demand only. While in an open input-output
model¸ both the intermediate and final demand are satisfied. Both the producer and non-producer
benefit.

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Relevance of the model
As already pointed the model helps in

o To determine the output levels of each sector to meet both the intermediate demand and
final demand.
o Understanding the interdependence of sectors in an economy. Understanding sectoral
linkages is valuable in understanding supply chains, identifying bottlenecks, and assessing
vulnerabilities to external shocks.
o Policy evaluation to evaluate the effectiveness of different policy interventions and
investment strategies. This helps plan for economic development of a regional or country
economy. Estimating the economic ripple effects of policy changes, policy makers,
planners etc. it can help make informed decisions and prioritize investments that yield
the highest economic returns.
o Assessing the impact of various shocks or policy changes in the economy e.g. the effects
of an increase in government spending, a change in trade policy, introduction of new
technologies etc.
o Understanding the effects of decision-making involving key sectors.
o Computing the gross national product GNP.

Basic Assumption of the model

For each sector there is a unit consumption vector in ℝ𝑛 that lists the inputs needed per unit of output of the sector
(Lay, 2003).

The Leontief Input-output Model

Consider the Leontief model
𝐱 C𝐱 𝐝
= +
Amount Produced Intermediate demand Final demand

Where C is the given coefficients matrix that contains all the technical coefficients.

Then we have; I𝐱 − C𝐱 = 𝐝 ⇒ (I − C)𝐱 = 𝐝

∴ 𝐱 = (I − C)−1 𝐝

where (I − C) − Leontief ′ s matrix with I as the identity matrix of the same order as matrix C.

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Example 1: We have seen that in the Leontief model the producing sectors in an economy are
interdependent i.e. the output of a sector is used as input of other sectors, however a percentage
of the output of each sector in the economy is also used for final consumption. That is output
has two types of demand;

Output = Input demand + Final demand

This can be visualized in a two-sector economy say A and B where S1 and 𝑆2 are the outputs of
sector A and B respectively. We can say that
D1 -output of A used as Final
S1 = x11 + x12 + D1 demand

x11 -output of A used as input in A

x12 -output of A used as input in
B

Similarly, we can have S2 as the output of sector B as follows;

D2 -output of B used as Final
S2 = x21 + x22 + D2 demand

x21 -output of B used as input in A

x12 -output of B used as input
in B

Therefore, we have the outflow system of equation as

S1 = x11 + x12 + D1
⋯ (∗)
S2 = x21 + x22 + D2
We can define;
xij
= aij ⇒ xij = aij Sj
Sj

With 𝑎𝑖𝑗 amount of output of 𝑖 𝑡ℎ sector is used as input in the 𝑗 𝑡ℎ sector to produce one unit of output
of the 𝑗 𝑡ℎ sector i.e. the input coefficient.

Therefore, we can rewrite the system (*) as follows;

S1 = a11 S1 + a12 S2 + D1
S2 = a21 S1 + a22 S2 + D2

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 S a11 a12 S1 D1 Final Demand
⇒ ( 1 ) = (a a22 ) (S2 ) + (D2 ) Vector
S2 21

Output Vector Input coefficient

matrix

S a11 a12 S1 D1
⇒ ( 1 ) − (a a22 ) (S2 ) = (D2 )
S2 21

a11 a12 S1 D1
(I − (a
21 a22 )) (S2 ) = (D2 ) ⋯ (∗∗)

a11 a12 S1 D1
Let (a a22 ) = C, (S2 ) = 𝐱, (D2 ) = 𝐝 then (**) becomes (I − C)𝐱 = 𝐝
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⇒ 𝐱 = (I − C)−1 𝐝 − Leontief input − output model

In general, for an economy with n producing interdependent sectors we have;

S1 = a11 S1 + a12 S2 + ⋯ … … … … … + D1
S2 = a21 S1 + a22 S2 + ⋯ … … … … . . . +D2
……………………………………………..
Sn = an1 Sn + an2 Sn + ⋯ + ann Sn + Dn

This can be reduced to 𝐱 = (I − C)−1 𝐝 – Static Leontief input-output model. Since the components
of final demand vector d are assumed to be autonomous.

Example 2: Consider a two-sector economy, agricultural A and manufacturing sector B.

Suppose the input-output coefficients and final demands for this economy are as follows;

X11 : 40% of A output is consumed by A

X12 : 20% of A output is consumed by B

X21 : 30% of B output is consumed by A

X22 : 50% of B output is consumed by B

Agricultural A Manufacturing B

Agricultural A 0.4 0.3

Manufacturing B 0.2 0.5

Table 1

The final demand for A is 200 units while the final demand for B is 300 units.
0.4 0.3
We can write the matrix of technical coefficients (technology matrix) C as; C = ( )
0.2 0.5

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 200
The final demand vector 𝐝 = ( )
300
(i) Determine the total production from each sector that will satisfy both the intermediate and
final demand.

Applying the Leontief model we have;

∴ 𝐱 = (I − C)−1 𝐝
1 0 0.4 0.3 0.6 −0.3
I−C=( )−( )=( )
0 1 0.2 0.5 −0.2 0.5
Next we find the determinant of I − C i.e.

Δ = (0.6 × 0.5) − (0.2 × 0.3) = 0.3 − 0.06 = 0.24

1 0.5 0.3
Therefore (I − C)−1 = 0.24 ( )
0.2 0.6
1 0.5 0.3 200 1 190 791.67
Hence 𝐱 = 0.24 ( )( ) = 0.24 ( )≈( )
0.2 0.6 300 220 916.67
⇒ A ≈ 791.67 units, B ≈ 916.67 units

(ii) Suppose the primary input for sector A and B constitutes 20% and 30% respectively,
determine the total primary input for the two sectors.

A = 0.2 × 791.67 ≈ 158.33; B = 0.3 × 916.67 ≈ 275 ⇒ Total ≈ 433.33

(iii) Account for sector A output;

Sector A

Consumed by itself 0.4 × 791.67 ≈ 316.67

Sold to the other sector B 0.3 × 791.67 ≈ 237.5

Final demand 200

Total output 754.17

(iv) Account for sector B input

Sector B

From sector A 0.3 × 916.67 ≈ 275

From itself 0.5 × 916.67 ≈ 458.34

Primary input 0.3 × 916.67 ≈ 275

Total input 1008.34

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Example 3: Consider a 3-sector economy in a coastal county as shown below, determine the
production level assuming the final demand is 100, 60, and 40 for manufacturing 𝑥1 , fishing 𝑥2 ,
and service 𝑥3 sectors respectively.

Input consumed per unit of output

Purchased by Manufacturing Fishing Service

Manufacturing 0.4 0.3 0.1

Fishing 0.3 0.4 0.2

Service 0.2 0.1 0.4

Table 2

Solution: by definition we have; (𝐼 − 𝐶)𝒙 = 𝒅 ⋯ (i)

1 0 0 0.4 0.3 0.1 0.6 −0.3 −0.1

Hence I − C = (0 1 0) − ( 0.3 0.4 0.2) = ( −0.3 0.6 −0.2)
0 0 1 0.2 0.1 0.4 −0.2 −0.1 0.6
0.6 −0.3 −0.1 100
Equation (i) becomes (−0.3 0.6 −0.2) 𝐱 = ( 60 ) ⋯ (ii)
−0.2 −0.1 0.6 40
x1
We can solve for vector 𝐱 = (x2 ) using Gaussian elimination method. We reduced to echelon
x3
form the augmented matrix of (ii) i.e.
0.6 −0.3 −0.1 100
A = (−0.3 0.6 −0.2 60 )
−0.2 −0.1 0.6 40
0.6 −0.3 −0.1 100 0.6 −0.3 −0.1 100
⇒ A = (−0.3 0.6 −0.2 60 ) 3𝑟3 + 𝑟1 ~ (−0.3 0.6 −0.2 60 ) 2𝑟2
−0.2 −0.1 0.6 40 0 −0.6 1.7 220
0.6 −0.3 −0.1 100
+ 𝑟1 ~ ( 0 0.9 −0.5 220)
0 −0.6 1.7 220

0.6 −0.3 −0.1 100

0.9𝑟3 + 0.6𝑟2 ~ ( 0 0.9 −0.5 220) = B
0 0 1.23 330
Matrix B is in echelon form, and it is row equivalent to matrix A.
330
From row 3 of matrix B we have; 1.23x3 = 330 ∴ x3 = 1.23 ≈ 268.3

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 330
From row 2 we have; 0.9x2 − 0.5x3 = 220 ⇒ 0.9x2 = 220 + 0.5 (1.23) ≈ 354.15 ∴ x2 ≈

393.5

From row 1 we have; 0.6x1 − 0.3x2 − 0.1x3 = 100

0.6x1 = 100 + 0.3x2 + 0.1x3 ≈ 100 + 0.3(393.5) − 0.1(268.3) = 191.22

x1 ≈ 318.7

Production levels for {x1 x2 x3 } = {318.7 393.5 268.3}

Example 4: (Closed input-output model ) Consider as simple economy with 3-sectors

Agriculture, Steel, and Petroleum, with their output as distributed among other sectors as shown
below, where the entries in the column represent the fractional parts of a sector total output.

Distribution of Output from:

Purchased by Agriculture Steel Petroleum

Agriculture 0.1 0.4 0.2

Steel 0.4 0.2 0.5

Petroleum 0.5 0.4 0.3

Table 3
Note that the columns of output add up to 1 since the entire output is consumed within these 3
sectors i.e. closed input-output model.

If we let Agriculture be 𝑥1 , steel 𝑥2 , and petroleum 𝑥3 then from the 3 rows we have;

x1 = 0.1x1 + 0.4x2 + 0.2x3

x2 = 0.4x1 + 0.2x2 + 0.5x3
x3 = 0.5x1 + 0.4x2 + 0.3x3

Amount produced Input Demand

We can rewrite the above to have a homogenous system;

−0.9x1 + 0.4x2 + 0.2x3 = 0
0.4x1 − 0.8x2 + 0.5x3 = 0
0.5x1 + 0.4x2 − 0.7x3 = 0
Next we write the augmented matrix of the system i.e.
−0.9 0.4 0.2 0
( 0.4 −0.8 0.5 0)
0.5 0.4 −0.7 0

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Then we row reduce the augmented matrix into its echelon form to get
−0.9 0.4 0.2 0 −0.9 0.4 0.2 0 −0.9 0.4 0.2 0
( 0.4 −0.8 0.5 0) 4r3 − 5r2 ~ ( 0.4 −0.8 0.5 0) 9r2 + 4r1 ~ ( 0 −5.6 5.3 0)
0.5 0.4 −0.7 0 0 5.6 −5.3 0 0 5.6 −5.3 0

−0.9 0.4 0.2 0

r3 + r2 ~ ( 0 −5.6 5.3 0) = B
0 0 0 0
Note that from row 3 of matrix B, x3 is a free variable.

From row 2; −5.6x2 = −5.3x3 ⇒ x2 ≈ 0.95x3

From row 1; −0.9x1 = −0.4x2 − 0.2x3 = −0.4(0.95x3 ) − 0.2x3 = −0.58x3 ∴ x1 ≈ 0.64x3

In conclusion, the equilibrium production levels is that agriculture must produce 64% of what
petroleum produces, and steel must produce 95% of what petroleum produces.

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Exercise
1) Theorem: Given a square matrix of order n and the identity matrix of the same order, if matrix A is
row equivalent to I then [A|I] is row equivalent to [I|A−1 ]. Use this theorem to find A−1
5 3
a) A = ( )
−2 7
2 2 3
b) A = (1 −3 2)
0 1 5
0.2 0.3 0.4
2) Consider the technological coefficients matrix A = (0.1 0.2 03 ). Suppose that the total
0.1 0.1 0.5
900
output is x = (400) determine the total internal demand. What is the total output required to
750
200
mee the following external demand d = (500)
400
3) The economy of a given country can be viewed from the goods sector and services sector.
To produce 100 million KES worth of goods requires 20million KES worth of goods and 10
million KES worth of services. Again, to produce 100 million KES worth of services needs
70 million KES worth of goods and 15 million KES worth of KES. Generate an input-
output matrix and hence calculate the value of goods and services needed in order to have an
export surplus of 800 million KES worth of goods and 650 million KES worth of service.
4) A county X simple economy consists of three sectors; Agriculture A, Manufacturing B,, and
Mining C. the input output matrix for this economy is given by
A B C
A 0.1 0.4 0.3
B [0.2 0.1 0.4]
C 0.3 0.5 0.1
a. Find the number of product A consumed in the production of 120 million KES
worth of goods B.
b. Determine the total input required to produce 1 unit of product C
c. Which sector consumes the greatest amount of mining products in the
production of a unit of goods in the sector? Which the least consumer?
d. What is the output from the economy required to meet an external demand of
250 million 450 million, and 372 million from sector A, B and C respectively.
e. Calculate the total internal consumption in meeting the above demand?

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5) It is given that Leontief’s inverse matrix is:
3.041.541.14
(I − A)−1 = [1.231.243.30]
2.513.014.23

a. Determine the primary inputs of each industry.

b. Determine the technical coefficients matrix.
c. Find the matrix (I – A)
d. Find the total output and the primary input required by each industry if the final
demand is 120, 230 and 240 for d1, d2, d3 respectively
6) Attempt practice problems in (Jacques, 2006, p. 513).

References

Jacques, I. (2006). Mathematics for economics and business (5th ed.). Prentice Hall.

Lay, D. C. (2003). Linear Algebra and its Application (3rd ed.). Pearson Education, Inc.

Lay, D. C., Lay, S. R., & McDonald, J. J. (2016). Linear Algebra and its Application (5th ed.).
Pearson.

Werner, F., & Sotskov, Y. N. (2006). Mathematics of Economics and Business. Routledge: Taylor &
Francis Group.

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