What Is a Lucas Wedge?
A Lucas Wedge is a measure of the loss of potential gross domestic product (GDP) when the economy does not grow as fast as it would have given optimal policy choices. It shows how much higher living standards would have been without the inefficiencies created by poor policy decisions, also known as the deadweight loss, that can contribute to economic sluggishness or recession.
Ultimately, a Lucas Wedge is a dollar amount that could have been spent on valuable consumer goods, investment in productive capital, improving roads, cleaning up the environment, battling deadly diseases, and improving everyone's collective wealth.
- A Lucas Wedge visually shows how much higher gross domestic product (GDP) would have been if not for economic sluggishness or a recession.
- A Lucas Wedge tends to expand greatly over time because its effects are cumulative and compounding.
- It should not be confused with an Okun Gap, which focuses on the difference between the output an economy produced over a given time frame versus what it could have produced at full employment.
Understanding the Lucas Wedge
A Lucas Wedge informs us of the price society pays when the economy experiences a downturn. It is a visual representation, illustrating where the economy would be if there was no loss of output and slowdown in GDP. The Lucas Wedge is a visual representation of the total forgone monetary or market value of all the finished goods and services produced within a country's borders in a specific time period.
A Lucas Wedge tends to expand significantly over time because it describes a deviation in the growth path of the economy so its effects are cumulative and compounding. This means that, in theory and often in the real world, a higher rate of productivity growth associated with avoiding recessions improves living standards far more in the long run (versus simply remaining at full employment).
Example of a Lucas Wedge
Calculations underlying a Lucas Wedge are quite complex. To simplify, let's assume an economy is represented by a single company that produced $1,000,000 of goods last year.
The company expected capacity to increase at 10% this year, or by $100,000. However, due to supply shortages, in the end growth was less than expected at only 3%, or $30,000. Based on this example, the Lucas Wedge, the difference between expected output and actual output, for the current year would be $70,000.
Going forward, the effects of the Lucas Wedge would continue and intensify. For example, assume that growth returns to 10% the following year. Total output would increase only by $103,000, or 10% of the prior year's output of $1,030,000. Expected output for this year, however, would have been $1,210,000, or an additional 10% from the previous year's expectation of $1,100,000. Even though growth returned to expectations, the expected output has increased from the previous year.
Therefore, the Lucas Wedge for the second year would increase to $147,000, reflecting both the $70,000 gap the first year and the $77,000 gap the second.
Lucas Wedge vs. Okun Gap
Economists, investors, and policymakers curious to know how much economic growth we missed out on due to a downturn can do so by analyzing 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. Both focus on unrealized economic output, although an Okun Gap's principal goal is to underline how a rise in unemployment affects the total monetary or market value of all the finished goods and services produced within a country's borders. In other words, an Okun Gap focuses on the difference between the output an economy produced over a given time frame versus what it could have produced at full employment. The Lucas wedge focuses on the difference between actual output growth, and how much output would have grown if economic policy choices had been optimized to produce maximum economic growth.
A Lucas Wedge should not be confused with an Okun Gap, which focuses on the difference between the output an economy produced over a given time frame versus what it could have produced at full employment.
An Okun Gap can occur in the absence of a recession or lull in the economy. Lucas Wedges also tend to be much larger, due to their cumulative and compounding effects over time. Because full employment at any given point in time can be achieved in multiple different ways, which might or might not maximize economic growth in a dynamic sense, an economy might have no Okun Gap in a given year, but might be experiencing a significant Lucas Wedge at the same time.
For example, if economic policymakers directed all workers and capital goods in an economy toward digging holes and filling them back in, with harsh legal mandates to enforce full participation by the population, the economy could be at full employment and thus experience no Okun Gap as long as the policy remained in place. However, it would likely experience a large Lucas Wedge from reduced economic productivity, which would be compounded in successive years even after the policy were to be removed. Though this may sound extreme, real world examples of a similar scenario can be seen in historical economic policies such as the Great Leap Forward.
A Lucas Wedge can also be calculated on a per-capita basis, reflecting the theoretical per-person growth in either nominal or real GDP, absent a recession. Using this method, it is possible to calculate how much better off each individual in an economy would have been, on average, in the absence of an economic slowdown, either in dollar terms or adjusting for inflation.