What it means
Imagine two lines on a chart of national output over several decades. One shows where the economy would be if it had carried on at its old trend rate of growth, and the other shows where it actually ended up.
The widening space between them is the wedge. The central insight is about compounding.
A difference of one percentage point in annual growth looks tiny in any one year, but over twenty or thirty years it builds into a large gap in output per person. Economists often express the wedge as the value of this lost output or lost consumption added up over the period.
Robert Lucas made a related argument in his work on the cost of business cycles, where he estimated that smoothing out recessions would add relatively little to people's welfare compared with the gains from higher growth. Whatever one thinks of the details, the wedge idea has been used to shift attention from short-run stabilisation to long-run productivity, investment and policy that supports growth.
For a business reader, the wedge is a way of thinking about slow-burn problems. A company whose revenue growth slips from 8% to 6% a year may not feel alarm in any single quarter, but the wedge between its old and new trajectory becomes very costly.
The same applies to national economies, sectors and individual product lines. The wedge is sensitive to the choice of trend.
Different assumptions about what growth rate should have been maintained give very different answers, so the numbers should be treated as an illustration of scale, not as a precise measurement.
In practice
Real-world examples.
Example
A government adviser shows ministers that a one percentage point fall in trend growth after a financial crisis leaves the economy with a gap of hundreds of billions in output within a generation. She uses it to make the case for investment in skills and infrastructure.
Example
A chief executive of a food manufacturer notices that sales growth has slipped from 7% to 5% a year. The finance director draws the two growth paths and shows that, over a decade, the lost revenue would equal building a new factory, which gets the board to focus on the cause.
Example
A university economics lecturer uses the wedge to explain to students why small differences in productivity growth between countries produce very different living standards after fifty years.
Formula
Calculation
Wedge in year n = Output at trend growth in year n - Actual output in year n
Suppose an economy starts at $1,000 billion. If it had grown at a trend rate of 3% a year for ten years, output would be 1,000 x 1.03^10 = about $1,344 billion. Because it grew only 2% a year, output is 1,000 x 1.02^10 = about $1,219 billion. The wedge in year ten is 1,344 - 1,219 = $125 billion. The accumulated loss across all ten years is larger still, because the gap grows every year.Case study
Seen in the real world.
Meridian Textiles is an illustrative, fictional company whose revenue had grown at 6% a year for a decade. After a change in strategy that cut spending on new product development, growth drifted down to 4% a year. No single quarter looked disastrous, and the board saw the slowdown as normal.
The new finance director plotted a wedge chart showing where revenue would have been at the old 6% trend. On revenue of $200,000,000, the gap after ten years was over $60,000,000 a year, and the board restored the development budget. The fictional story shows how a visual of the wedge can make a slow decline feel as urgent as a sudden one.
Watch out
Common mistakes.
- Assuming a small growth difference is unimportant, when compounding makes it very large over a long period.
- Treating the wedge as a precise measurement, when it depends heavily on the trend rate chosen as the benchmark.
- Confusing the Lucas wedge with the output gap, which compares actual output with the economy's potential at a single point in time.
Questions
People also ask.
Who was Robert Lucas?
He was an American economist who won the Nobel Memorial Prize in Economic Sciences in 1995 for his work on rational expectations, and his name is attached to several ideas in macroeconomics.
Why does the wedge keep growing?
Each year's shortfall is carried forward and itself compounds, so the gap between the two paths widens at an increasing pace.
How is the idea useful in business planning?
It helps leaders see the long-run cost of slightly weaker growth, so that slow declines receive the same attention as sudden shocks.
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