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 could have otherwise. It shows how much higher living standards would have been without the inefficiency or poor policy decisions, also known as the deadweight loss, that belie economic sluggishness or recession. Ultimately, this is a dollar amount that could have been spent on improving roads, cleaning up the environment, battling deadly diseases and improving everyone's collective wealth.

The term Lucas Wedge should not be confused with an Okun Gap, another measure of potential GDP that focuses on the difference between the output an economy produced over a given time frame versus what it could have produced at full employment. Note than an Okun gap can occur in the absence of a recession or lull in the economy.

A Lucas Wedge tends to expand greatly over time because its effects are cumulative and compounding. This causes a Lucas Wedge to typically be far larger than an Okun Gap. 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.

Calculations underlying a Lucas Wedge can be 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 expects capacity to increase at 10% this year, or $100,000. However, due to supply shortages, growth at the end of this year was only 3%, or $30,000. The Lucas Wedge for the current year would be $70,000, or the difference between expected output and actual output.

Going forward, the effects of the Lucas Wedge would continue and intensify. The next year, assume that growth returns to 10%. 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, increasing, even though growth returned to expectations.

Therefore, the Lucas Wedge for the second year would increase to $180,000, reflecting both the $70,000 gap the first year and the $110,000 the second.

Also note that one can calculate a Lucas Wedge on a per-capita basis, reflecting the theoretical per-person growth in either nominal or real GDP, absent a recession. In this way, one can use it to calculate how much better off each individual in an economy would have been, on average, absent an economic slowdown, either in dollar terms or adjusting for inflation.