APRIL 17th – 4TH LESSON

THE INPUT – OUPUT MODEL

Economic impacts of one sector (or a new firm) on an economy

is usually measured by an analytical tool (model) called “input
output model”

Input-Output model is not only a theory of production but also

an effective application of the Walrasian general equilibrium
analysis.

It’s also an application of the general equilibrium analysis

because it consists of a system of simultaneous equations
describing demand for and supply of each sectoral output.

The model also describes a structural interdependence among

the various economic sectors of a region or nation. E.g. an
economy can be divided into various economic sectors called
“industries” producing different products. Each activity say X1
requires a certain number of inputs produced by other
industries in order to produce its own production. By the same
time, other industries X1, i=2……….n requires a certain
number of inputs produced by industry X1 and others to
produce their own production.

Example 1:
A hypothetical input-output table for a five sector economy.
The four quadrants of the input-output model
S S1 S2 S3 S4 S5 TI HO IN EX TF TO
D U V P D
S1 20 10 30 5 25 90 40 5 30 75 165
S2 10 0 15 0 8 33 5 0 20 25 58
S3 35 7 4 3 11 60 0 10 10 20 80
S4 5 8 1 14 12 40 0 15 5 20 60
S5 20 8 10 18 0 56 15 15 5 35 91
TP 90 33 60 40 56 279 60 45 70 175
IM 20 10 0 5 14 49 5 5 0 (10 49
P )
T 20 5 10 5 4 44 (20 (0) (10 (30 44
) ) )
HO 15 3 5 3 4 30 2 0 0 2 32
U
CA 10 2 5 0 10 27 0 0 0 0 27
P
NR 10 5 0 7 3 25 0 0 0 0 25
VA 55 15 20 15 21 126 2 0 0 2 128
TI 165 58 80 60 91 454 67 50 70 177 631

Notes//
TID = Total Intermediate demand, CAP = Capital
EXP = exports, TP = Total
purchases
HOU = Households, T=Taxes
(government)
INV = investments, NR= Natural
resources
TFD = Total Final Demand VA= Value
Added
TO =Total output, TI=Total Input
IMP=Imports
Interpretation:
 The output of industry S1 is the sum of (TID)+TFD where
TID=20+10+30+5+25 = sh.90
TFD=40+5+30 = sh.75
Hence the total production of industry S1=sh.165 (90+75)
  The transaction of sh.10 in row S1 and column S2 indicates that
industry S2 purchases sh.10 worth of output from industry S1 to
produce its output.
 The value added(VA) of column S1 which equals sh.55 is
obtained by summing sh.20, 15, 10, 10; the sum of T, HOU,
Capital and Natural resources of column S1 is equal to the sum
of TP, IMP and VA i.e.(90+20+55)=sh.165. The transaction of
sh.20 in row T, and column HOU indicates that households pay
sh.20 to the government as taxes. Other transactions can be
interpreted similarly.
Assumptions of input – output model.
1. This model assumes that there’s a single process production
function for every industry (sector). Example, the single
production function for column S3 industry is
X3=Xi3/ai3 for i=1,2,…..n.
In general for industry (j) one can write a single production
function as
Xj= Xij/aij =X2j/a2j = Xij/anj
This assumption can be broken down into two:
a) Constant returns to scale – i.e. if input increases by 10%, output
will also increase by 10%
b) Zero substitution among inputs – The isoquant of the production
function is of L-shape. Since one method of production exist,
the planned output level determines the required level of inputs
as the technical coefficient (aij) are constant
c) Additivity assumptions
It’s used to rule out external economies and diseconomies. Once
these economies and diseconomies are excluded, the remaining
conditions under which output is produced is the constant return
to scale.
To be
continued********************************************
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Example 2
The following is a two – sector economy whose input-output
table is:
Final demand
X
S1 S2 HOU EXP
TOTAL OUTPUT

S1 85 260 25 150 520

S2 110 55 200 650 1015

HOU 150 250 25 75 500

NR 175 450 250 200 1075

TOTAL 520 1015 500 1075

INPUT

Find matrix (A) for input-output model and interpret its elements
Solution:
a11 = AX11 /X1 = 85/520 =0.16346
a12 = X12 /X2 = 260/1015 = 0.2516
a21 = X21 /X1 = 110/520 = 0.21154
a22 = X22 / X2 = 55/1015 = 0.05419
Thus A = 0.16346 0.2516
0.21154 0.05419
 Interpretation:
The first element of (0.163461) says that to produce a dollar’s
worth of output, the first sector has to purchase inputs worth of sh.
(0.163461) from itself.
The second element of sh. (0.21154) suggests that the first sector
has to purchase input worth of sh (0.21154) from the second sector
in order to produce a dollar’s worth of output.
The third element indicates that the second sector has to buy input
worth sh. (0.25616) from the first sector in order to produce a
dollar’s worth of output. Similarly the second sector has to buy sh.
(0.5419) worth of output from the second sector in order to
produce a dollar’s worth of output.
MARKOV ANALYSIS:

This is a stochastic or probabilistic system whereby the state of a

given phenomenon in the future can be predicted from the current
state using a matrix of transition probabilities i.e. it’s a quantitative
technique that combines the use of probabilities and matrices in the
prediction of future behavior of some variable by using the current
behavior of that variable.

This analysis is used to analyze decision problems in which the

occurrence of a specified event depends on the occurrence of a
previous event.

Areas of application

The Markov processes or chains are frequently applied as

follows:

1. Brand Switching
By using transitional probabilities, we can be able to express the
manner in which consumers switch their tastes from one product to
another.
 2. Insurance Industry
Markov analysis may be used to study the claims made by the insured
persons and also decide the level of premiums to be paid in future

3. Movement of urban population

By formulating a transition matrix for the current population in the
urban areas, one can be able to determine what the population will be
in say 5 years.

4. Movement of customers from one bank to another

It’s a fact that customers tend to search for efficient banks, therefore
at a certain time when a given bank installs such machinery as
computers, this tends to attract a number of customers who will move
from a certain bank to a more efficient one.

5. Finance
Used to predict share prices in the stock exchange market

6. Human resource management

To analyze shifting of personnel within the organization’s units e.g.
branches, departments etc.

7. Accounting
To estimate provision for bad debts

8. To analyze equipment replacement and failure problems

9. Introduction of new products in the market
Basic terms in Markov Chains
a) Probability vector
This is a row matrix whose elements are non-negative and also they
add up to one, e.g. µ = (0.2, 0.1, 0.2, 0.5)
Example:
State which ones are probability vectors?
µ = (3/4 , 0, -1/4 , 1/2) - Not because of -1/4 is negative
v = (3/4, ½ 0, ¼) Not because the sum of elements is greater than
1
w = (1/4 , ¼ , 0, ½) Adds up to 1, each element is non-negative
therefore it’s a probability vector.
b) Stochastic matrix
A matrix whose row elements are all non-negative and also add up to
1.

Example: M = 0.1 0.2 0.3 0.4

0.0 0.7 0.1 0.2
0.5 0.1 0.1 0.3
0.3 0.4 0.2 0.1

State which matrices are stochastic?

A= 1/3 0 2/3 ¼¾ 0 1 0
¾ -1/2 -1/4 B= 1/3 1/3 C = ½ 1/6
1/3
1/3 1/3 1/3 1/3 2/3 0
A is not a stochastic matrix because the element in the 2 nd row is
negative
B is not a stochastic matrix because elements in the second row do not
add up to 1
C is a stochastic matrix because each element is non- negative and
they add up to 1 in each row,

c) Regular stochastic matrix

A matrix P is said to be regular if all elements in P m are all positive.
Where m is a power, m = 1, 2, 3 etc.
Let A = 0 1
 0.5 0.5 Where A is a stochastic matrix, then

A2 = 0 1 0 1 0.5 0.5
0.5 0.5 x 0.5 0.5 = 0.25 0.75

A3 = 0.5 0.5 0 1 0.25 0.75

0.25 0.75 x 0.5 0.5 = 0.375 0.625
Since elements A and A are all positive then A is a regular stochastic
2 3

matrix.
d) State - Any identified possible condition of a process or a
system e.g. a machine can be in one of the two states at any
point in time.
e) Markov process – A stochastic process where the future state
depends on the current state
f) State probability – Probability of an event occurring at a point in
time.
g) Vector of state probabilities – Row matrix of all state
probabilities for a given system or process
h) Transition probability – Conditional probability that will be in a
future state given the current or existing state ( probability of
moving from one state to another)
i) Matrix of transition probability – Matrix containing all transition
probabilities for a certain process or system
j) Equilibrium condition – A condition that exists when the state
probabilities for a future period are the same as the state
probabilities for a previous state
k) Absorbing state – A state when entered cannot be left. It has a
transition probability of unity to itself and zero to all other
states. They include; Payment of a bill, termination of
employment, completion of a contract, sale of a capital asset.
l) Steady state
Refers to long run state of the system, provided assumption of the
markov process persists, the system finally reaches equilibrium
called steady state.
m)Recurrent state – Refers to a state that can be left and re-entered
many times
 n) Closed state – A state which once left cannot be re-entered

MARKOV ANALYSIS ASSUMPTIONS

1. Probability of movement from one state to another over time can
be determined and remains constant over the period under
consideration.
2. Current state of the system depends only upon the immediate
preceding state of the system and not any prior state
3. All states of the system are known and can be listed down
4. The various states are mutually exclusive and collectively
exhaustive i.e. at any given time a subject of analysis belongs to
one and only one state.
5. No new states can join the system and none of the states in the
system can leave
6. The number and composition of possible states do not change

Forecasting using a markov process

Forecasting is possible once we have initial states and the transition

matrix

To

S1 S1 …………………………….Sn

Transition matrix, T=from S2 P11…………………………….P1n

: P21………………………………………….P2n

: : :

Sm : Pmn
Notes

a) P11 is the conditional probability of the system being in state

j in future if the current state is i
b) P11 + P12 + ………….+ P1n =1
P21 +P22 + …………..+ P21 = 1
c) T is a square matrix
d) T is obtained empirically i.e. Through observation, data
collection and analysis
MARKOV ANALYSIS METHODOLOGY

The markov process involves 4 major steps one has to go through in

order to predict the future status of a given variable.

Steps:

1. Determine the current or initial probability for each of the

different states of the system. Such probability is called Market
Shares. Normally symbolized by a row vector that gives the
probability at period zero of the said variable
2. Formulate the transition probability Matrix T
3. Predict the future behavior of the system
The position of the system at a given period will be computed by
multiplying the preceding period’s market shares by the matrix of
transition probabilities, T. Example, the position of a variable at
different time periods will be obtained by using the model below.

Position at period 0(now) = V (0)

Position at period 1, (V1) = V (0) x T

Position at period 2, (2) = V (1) x T = V (0) x T x T=V (0) x T2

Position at period 3, (3) = V (2) x T = V (0) x T2 x T

Position at period n, V (n) = V (n-1) x T = V (0) x Tn

 Therefore the general markov analysis model for prediction of
what to expect in any given period, n in the future is V n = V(n-1) x
T = V (0) x Tn

Steady state (equilibrium) condition

After a number of transitions, probabilities are expected to stabilize

or come to an equilibrium position as the rate of exchange
decreases with time. This implies that a time will come when the
current variable values (probabilities) equal to the succeeding
period probabilities throughout thus a steady state exists if a state
probabilities do not change for a large number of periods. If we
suppose that these final fixed equilibrium market shares are p and q
then [pq] x T = [pq] for all periods after equilibrium period.

illustration

Two TV stations S1 and S2 compete for viewers; of those who view

S1 on a given day, 40% view S 2 the next day. In case of those who
view S2 on a given day, 30% switch over to S 1 the next day.
Suppose yesterday; of the total viewers 60% view S 1 and the rest
S2. Determine the percentage of viewers for each station

a) Today
b) Tomorrow
c) At equilibrium/steady state or in the long run
Solution:

To
s1 s2 []
Transition matrix m, T = from s 1 1 0
s2 0 1

s1 s2
Initial state vector 0.6 0.4 (Yesterday)
s1
s1

s1 s2 [0.6
0.4]
a) Today’s market share (% of viewers) = ( 0.6 0.4) [0.3
0.7]
1 by 2 2
by 2

Therefore, 0.6 x0.6 + 0.40x 0.3, 0.6 x 0.4 + 0.4 x 0.7

s 1= 0.48 s 2= 0.52

b) Initial state vector = (0.48 0.52)

[0.6 0.4]
Tomorrow’s market share = (0.48 0.52) [0.3 0.7]
= 0.48 x 0.6 + 0.52 x 0.3 ; 0.48 x 0.4 + 0.52 x 0.7
0.444 (44.4%) 0.556 (55.6%)

c) Provided the assumptions of the markov process hold, the

system finally reaches equilibrium (steady state, long term or
long run status).
At equilibrium the following hold, Equilibrium (state vector) T =
Equilibrium state vector.
Let p = long term % of viewers (market share) for S1
q= long term % of viewers (market share) for S2

p + q =1 ; q=1-p

S1 S2
In the long term, (p, q) 0.6 0.4 = (p, q)
0.3 0.7
0.6p + 0.3q = p
0.4p + 0.7q =q
Drop one of the equations arbitrarily; hence
0.6p + 0.3 q =p
0.3q = p- 0.6p; 0.3q = 0.4p
P + q = 1. Therefore p = 1 – q
0.3q = 0.4 (1 - q); 0.3q = 0.4 -0.4q
0.3q + 0.4q =0.4
0.7q = 0.4, q = 0.4/0.7 = 0.5714, 57.14%
Since p + q = 1 then, p = 1 – 0.5714 = 0.4286, 42.86%