Indirect effects: Meaning, Criticisms & Real-World Uses

What Are Indirect Effects?

Indirect effects refer to the secondary or ripple consequences that occur throughout an economy as a result of an initial economic activity, policy, or event. These effects are a core component of economic impact analysis, which seeks to measure the total influence of a specific action on a defined economic region. Unlike direct effects, which are the immediate and primary outcomes, indirect effects represent the business-to-business transactions and other economic responses that are stimulated or suppressed further along the supply chains. They capture how the initial spending or activity prompts subsequent rounds of spending and production within related industries, generating broader economic activity that extends beyond the initial beneficiaries. The comprehensive assessment of indirect effects is crucial for understanding the true scale of an economic event.

History and Origin

The concept of tracing economic impacts beyond immediate, visible transactions has roots in classical economic thought. Early economists, such as Frederic Bastiat in the 19th century, emphasized the importance of looking beyond the obvious or immediate consequences of policies and actions to understand their full, often unforeseen, implications. Bastiat argued that a "good economist" considers not only the direct consequences but also the "longer and indirect consequences" of a proposed course of action⁶. This fundamental idea laid intellectual groundwork for later formal methodologies, such as input-output models, developed in the 20th century, which became instrumental in quantifying these more complex, interconnected economic relationships. These analytical frameworks allowed economists and policymakers to systematically estimate the broader economic ripples, distinguishing between the initial impact and the subsequent, indirect effects that spread through an economy.

Key Takeaways

Indirect effects are secondary economic consequences that arise from an initial direct action or event.
They capture business-to-business transactions within supply chains that occur due to the direct effects.
Understanding indirect effects is vital for a comprehensive economic impact analysis.
These effects contribute to the overall multiplier effect in an economy.
Indirect effects can often be more challenging to measure than direct effects due to their diffused nature.

Formula and Calculation

Unlike a single, universal formula, indirect effects are typically estimated using macroeconomic models, most commonly the input-output model (I-O model). This model quantifies the interdependencies between different sectors of an economy.

The calculation of indirect effects within an input-output framework involves complex matrices that track how changes in demand in one industry propagate through the economy as that industry purchases goods and services from its suppliers, and those suppliers, in turn, purchase from their suppliers.

In simplified terms, the output of the direct sector requires inputs from supporting industries. The demand for these inputs constitutes the indirect effect. The I-O model uses multipliers to estimate the full magnitude of these inter-industry transactions.

For a specific economic impact study, the indirect output ($IO$) can be generally conceptualized within the I-O framework as:

IO = A \times X_D

Where:

$A$ represents the matrix of technical coefficients (often derived from an inter-industry transactions table), showing how much input from each industry is required to produce one unit of output in another industry.
$X_D$ represents the vector of direct economic impacts (e.g., direct output or initial spending).

This calculation traces how the initial direct spending cascades through intermediate purchases, generating additional rounds of economic activity among suppliers within the defined region.

Interpreting Indirect Effects

Interpreting indirect effects involves understanding how an initial economic stimulus or shock propagates through an economy beyond its immediate point of impact. When analyzing indirect effects, the focus is on the transactions between businesses that occur as a consequence of the direct economic activity. For instance, if a new manufacturing plant (direct effect) is established, it will require raw materials, components, utilities, and services from other local businesses. These purchases by the plant from its suppliers represent the indirect effects. These supplier businesses then, in turn, purchase from their own suppliers, creating further rounds of indirect activity.

The magnitude of indirect effects can vary significantly depending on the interconnectedness of the local supply chains and the extent to which the necessary inputs can be sourced within the study region. A higher proportion of local sourcing generally leads to larger indirect effects. Analysts interpret these figures to understand the broader industrial support generated by a project or policy, providing insight into which sectors benefit from increased business-to-business transactions. This level of detail is crucial for policymakers assessing the comprehensive impact of investment or regulatory changes on regional economic growth.

Hypothetical Example

Imagine a large university decides to build a new research facility in a small town. The direct effect is the spending on the construction of the facility itself—wages for construction workers, purchases of steel, concrete, and other materials.

The indirect effects begin as the local construction companies, benefiting from the university's direct spending, then increase their own purchases. For example:

Construction Company Purchases: The primary construction company buys more lumber from a local lumberyard. This is an indirect effect.
Lumberyard Purchases: To meet the increased demand, the lumberyard then purchases more timber from a regional logging company. This is a further indirect effect.
Equipment Maintenance: The construction company also increases its spending on maintaining its heavy equipment, buying more parts and services from a local machinery repair shop. This is another indirect effect.
Office Supplies: The construction company's administrative office might purchase more office supplies from a local vendor to handle the increased paperwork for the large project. This too is an indirect effect.

These business-to-business transactions represent the flow of money and demand through the economy, as industries respond to the needs created by the initial construction project. This demonstrates how the university's investment creates a ripple effect, supporting various local businesses and their employees who are not directly involved in the construction itself.

Practical Applications

Indirect effects are a critical consideration across various domains, providing a more complete picture of economic influence.

In economic development, understanding indirect effects helps justify investments in new industries or infrastructure. For example, a new port facility has direct effects on shipping companies and port workers. Its indirect effects would include increased demand for logistics firms, trucking companies, and warehousing services that support the port's operations, leading to broader economic growth in the region.

Government policy decisions often have significant indirect effects. Changes in monetary policy, such as adjustments to interest rates by a central bank like the Federal Reserve, don't just directly influence borrowing costs. They can indirectly impact consumer spending habits, business investment, and the overall trajectory of the economy by affecting financial conditions more broadly, including mortgage rates and asset prices. ⁵Similarly, fiscal policy measures, like government spending on a new public project, will generate indirect demand for a wide range of goods and services from supporting industries.

On an international scale, the International Monetary Fund (IMF) regularly analyzes "spillover effects," which are essentially cross-border indirect effects, to understand how the economic policies or events in one country can impact others. ⁴For example, a major economic downturn in one large economy can indirectly affect its trading partners by reducing demand for their exports and disrupting global supply chains.

Limitations and Criticisms

While essential for comprehensive analysis, the estimation of indirect effects is not without limitations and criticisms. One significant challenge lies in the quality and availability of input data for the economic models used to calculate these effects. Inaccurate or outdated data can lead to misleading projections.

Critics also point out that economic impact studies, particularly those focusing on indirect effects, often do not adequately account for opportunity cost. This means they may highlight the new economic activity generated but fail to fully subtract the activity that might have occurred elsewhere in the economy if the resources (labor, capital) had been used for an alternative purpose. ³This can lead to an overestimation of the net benefits.

Furthermore, the complexity of real-world economic systems means that models, by necessity, simplify interdependencies. This simplification can sometimes miss unforeseen and negative indirect consequences, where a policy intended to produce positive outcomes inadvertently creates undesirable ripple effects. For example, a new regulation designed to promote one industry might indirectly stifle innovation or increase costs in a related sector, leading to unintended negative consequences,.² ¹The models may also struggle to capture dynamic changes in industries or shifts in consumer behavior over time, potentially leading to discrepancies between predicted and actual indirect impacts.

Indirect effects vs. Direct effects

The distinction between indirect effects and direct effects is fundamental in economic impact analysis.

Direct effects are the immediate, primary, and measurable outcomes of an economic event or activity. They represent the initial spending, employment, and output generated by the project, policy, or organization being studied. For instance, if a factory opens, the wages paid to its employees and the sales revenue it generates from its products are direct effects.

Indirect effects, in contrast, are the secondary impacts that occur as a result of the direct effects, primarily through business-to-business transactions within the supply chain. These are the ripple effects as the directly impacted businesses purchase goods and services from other local businesses to support their operations. Using the factory example, when the factory buys raw materials from a local supplier, that supplier's increased sales constitute an indirect effect. Similarly, the local utility company providing power to the factory experiences an indirect benefit.

The key difference lies in the nature of the transaction: direct effects are the initial, first-round transactions, while indirect effects are the subsequent transactions between supporting industries that supply goods and services to those directly impacted. Both are distinct from induced effects, which stem from the re-spending of income by households that receive wages or profits from both direct and indirect activities.

FAQs

What is the difference between indirect and induced effects?

Indirect effects relate to business-to-business purchases within the supply chain (e.g., a restaurant buying ingredients from a local farm due to increased customers). Induced effects, on the other hand, arise from the increased household spending of wages and profits earned from both direct and indirect activities (e.g., the restaurant staff spending their increased earnings at other local businesses).

How are indirect effects typically measured?

Indirect effects are commonly measured using economic models, primarily input-output models, which map the interdependencies between various industries in an economy. These models use multipliers to estimate how initial spending generates subsequent rounds of business-to-business activity throughout different sectors.

Can indirect effects be negative?

Yes, indirect effects can be negative. While often discussed in the context of positive economic stimulus, an economic downturn or a policy that negatively impacts a primary industry can lead to reduced demand for its suppliers and supporting businesses, creating a negative ripple effect through the economy. For example, a decline in manufacturing output could indirectly harm local raw material suppliers.

Are indirect effects included in the calculation of Gross Domestic Product (GDP)?

When calculating Gross Domestic Product (GDP) or Gross Regional Product (GRP) for an economic impact study, the value added by indirect effects (i.e., the contribution to income and profits from supporting industries) is included in the overall economic impact assessment. These effects represent actual economic activity and contribute to the total economic output of a region.