The Economy and You #17: What is the Multiplier Effect

When a new business announces that it is going to locate within a community, often people will read stories and reports that estimate the effect it will have on the local economy.  These analyses are used to quantify the impacts that will occur due to one specific project and what the multiplier effects will be.  Communities across the country have used impact analysis studies to show the positive impacts of a proposed shopping mall, manufacturing plant, mine, or casino.  The reports often state that for every $1 spent directly on the project will lead to an additional amount spent indirectly in the community.  This is the multiplier effect.

The multiplier effect (or regional multiplier) is a calculation which shows the additional, or indirect, change to an economy as a result of an expansion or contraction by a business or industry.  Multipliers can be used to estimate how a new manufacturing plant will impact a community through the jobs it creates, the incomes it generates, and the additional spending that occurs as a result of the initial development activity. In contrast, the multiplier can be used to estimate the economic loss that would occur with the closing of a plant.

In the 1970′s, the Bureau of Economic Analysis of the Department of Commerce (BEA) developed a method (using input-output models) for estimating regional multipliers known as the Regional Industrial Multiplier System (RIMS). RIMS can be used to estimate the total impact of the project or program on regional output, earnings, or employment.  RIMS is now widely used as an analysis tool.  In the public sector, the Department of Defense uses RIMS to estimate the regional impacts of military base closings, and Departments of Transportation in most states use it to estimate the regional impacts of airport construction and expansion.  In the private sector, analysts and economic development professionals use RIMS to estimate the regional impacts of a variety of projects, such as industrial parks, shopping malls, and sports stadiums.

So how is a regional multiplier calculated? Generally, the initial increase in spending (the construction of a plant) leads to an increase in regional income (from jobs created) which leads to additional spending which creates additional income which creates additional spending and so the process continues until any additional spending is inconsequential. The total impact is calculated by adding the initial spending (direct impact) with the total “respending” (indirect impact) in the region.  Analysts use economic input-output models to calculate each of these numbers to determine the multiplier (also known as an industry coefficient).  As an example, for each dollar a company spends to build a plant, it creates 65 cents of additional spending.  This would mean that the project has a multiplier of 1.65 with 1.00 be the direct impact and the .65 being the indirect impact.

Multipliers can vary widely by region and/or industry.  Because of this, the size of a multiplier can indicate the relationship of an industry to a regional economy.  Regions with a diverse mix of industries tend to have higher multipliers.  In addition, businesses that buy most of their supplies and materials locally have higher multipliers.

Multipliers tend to be higher for industries in large urban areas because more of the spending by the industry stays in the area.  Small rural areas generally must use outside firms for supplied and services and therefore have lower multipliers.

The Multiplier Calculation Process

The Multiplier Calculation Process

As the chart shows, for every dollar of spending that enters the region, 40 cents is spent again within the region on various goods and services.  This “respending” continues and totals approximately 65 cents in additional spending, making the regional multiplier 1.65.

It is important to note that multipliers do not always measure indirect impacts to the economy correctly.  This is because the assumptions regarding the purchase of goods and services are not fixed.  Before a new industry is located in a community, the proportion of supplies bought from local and outside companies is fixed. The introduction of a new business will often change these proportions which can result in an inaccurate estimate of economic impact.  As a result, multipliers can overstate indirect impacts.

Multipliers should be applied to projects that are a genuine source of new activity in a region.  Incoming businesses are not always a net source of new jobs and income because they could be taking away business from existing firms.  They only create indirect impacts if they capture spending that had left the area or attract new spending from outside the area.

While multipliers have challenges with regards to their calculation, they are an important tool for community and decision makers.  Multipliers provide a comprehensive picture of a regional economy and present a large amount of economic data in a concise and easy to understand fashion.

December 14, 2011 | Categories: Economy, Financial Education | Tags: Economic impact analysis, Economy, Multiplier (economics), Treasury, wisconsin | 1 Comment »