Lucas Wedge What It is How it Works Example

Lucas Wedge What It is How it Works Example

Lucas Wedge: What It is, How it Works, Example

What Is a Lucas Wedge?

A Lucas Wedge measures the loss of potential gross domestic product (GDP) when the economy does not grow as fast as it could have due to poor policy choices. It represents the deadweight loss, or inefficiencies, that contribute to economic sluggishness or recession.

Ultimately, a Lucas Wedge represents the dollar amount that could have been spent on valuable consumer goods, investment in productive capital, improving infrastructure, environmental cleanup, disease prevention, and overall wealth improvement.

Key Takeaways

– A Lucas Wedge visually shows the higher GDP that could have been achieved without economic sluggishness or recession.

– A Lucas Wedge tends to expand over time due to its cumulative effects.

– It is distinct from an Okun Gap, which focuses on the difference between actual output and potential output at full employment.

Understanding a Lucas Wedge

A Lucas Wedge illustrates the price society pays during an economic downturn. It visually represents where the economy would be without the loss of output and GDP slowdown. The Lucas Wedge represents the forgone market value of all finished goods and services produced within a country in a specific time period.

A Lucas Wedge tends to expand significantly over time as it indicates a deviation from the economy’s growth path. This means that a higher rate of productivity growth, associated with avoiding recessions, greatly improves living standards in the long run.

Example of a Lucas Wedge

Calculating a Lucas Wedge is complex. Let’s simplify with an example: an economy represented by a single company that produced $1,000,000 of goods last year.

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Expected capacity growth for this year was 10% ($100,000), but due to supply shortages, growth only reached 3% ($30,000). Thus, the Lucas Wedge, the difference between expected and actual output for this year, would be $70,000.

In the following year, growth returns to 10%. The total output increases to $1,030,000. However, the expected output for this year would have been $1,100,000. Therefore, the Lucas Wedge for the second year would be $147,000, reflecting the $70,000 gap from the previous year and a $77,000 gap for the current year.

Lucas Wedge vs. Okun Gap

To assess how much economic growth is missed due to a downturn, economists, investors, and policymakers analyze the difference between actual GDP and potential GDP, also known as Okun’s Gap.

The Lucas Wedge should not be confused with an Okun Gap. While both focus on unrealized economic output, an Okun Gap specifically highlights the impact of unemployment on the total market value of finished goods and services. On the other hand, the Lucas Wedge examines the difference between actual output growth and potential growth based on optimized economic policy choices.

An Okun Gap can occur without a recession, while Lucas Wedges tend to be larger due to their cumulative effects over time. An economy may experience no Okun Gap but have a significant Lucas Wedge simultaneously.

Special Considerations

A Lucas Wedge can also be calculated on a per-capita basis, reflecting theoretical growth in GDP per person, either nominally or adjusted for inflation. This provides insight into how each individual in the economy would have been better off without an economic slowdown.

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