An extension of the hypothetical extraction method: endogenous consumption and the Armington treatment of imports

The hypothetical extraction method (HEM) is the tool of choice for identifying underlying economic interdependencies. It provides critical information to policymakers regarding the strategic role of different sectors. However, the standard implementation of the HEM does not include the impact that falls on the price structure as a result of the substitution between domestic and imported products that takes place after the extraction of a sector or industry, in this case. We propose to overcome this limitation by extending the HEM using an Armington-Leontief model with endogenous consumption. Unlike the perfect substitution assumption typical of the standard HEM, the Armington assumption with endogenous consumption implies that the shift from domestic inputs to imports affects the cost functions. Therefore, both quantities and prices become endogenous in the ‘post-extraction' equilibrium. We also argue that HEM indicators should be expanded beyond the typical output-related indicators, i.e. value-added, employment, or pollutant levels, so that summary indices of the type more commonly used in economics, such as welfare indicators, are used. We implement this novel approach using the latest input–output data for Spain in 2016.