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# Supply Shock

Have you ever been shocked by something? Maybe a nearby thunderstorm dropped a bolt of lightning near your house and it startled you. Perhaps you got some really good news from a friend and you were suddenly very happy! Or maybe you got a huge, unexpected raise from your employer and you were, well, shocked! These events are all unexpected and happen suddenly. In a similar way, unexpected and sudden things can happen that shock the economy. It can happen to both supply and demand, and the shocks can be positive or negative. If you would like to know more about supply shocks, then let's dive in!

## Supply shock definition economics

What is the supply shock definition in economics? A supply shock in economics is defined as an unexpected rapid change in the aggregate supply of the economy at any given aggregate price level. A supply shock can be positive or negative. A positive supply shock is represented by a rightward shift of the short-run aggregate supply (SRAS) curve, while a negative supply shock is represented by a leftward shift of the SRAS curve. In economic terms, these shifts happen relatively quickly and take the economy by surprise.

A supply shock is an unexpected rapid increase or decrease in aggregate supply at any given aggregate price level.

### Causes of Supply Shocks

There are many causes of supply shocks. Let's take a look.

#### Input Prices

Changes in input prices are a major cause of supply shocks. Because producers decide what and how much to produce based on profits, anything that impacts their unit production costs can shift supply one way or the other. If there is an increase in labor costs, which are a large portion of production costs, producers' unit production costs will rise, thereby reducing their profits. Thus, they will produce less at any given aggregate price level, which will shift the SRAS curve to the left (from SRAS1 to SRAS2) and increase the aggregate price level (from PL1 to PL2), as in Figure 1 below.

Fig. 1 - Negative Supply Shock

If equipment prices decline, that would reduce production costs and increase profits, which would lead producers to supply more at any given aggregate price level. This would shift the SRAS curve to the right (from SRAS1 to SRAS2) and decrease the aggregate price level (from PL1 to PL2), as in Figure 2 below.

Fig. 2 - Positive Supply Shock

There are also imported resources to consider. Since crude oil is an input for a large part of the economy, any change in crude oil prices can have economy-wide effects. Let's say a war breaks out in an oil-producing region of the world. Fear that the region will produce less oil will cause an increase in the price of crude oil. In turn, any country that imports crude oil will pay a higher price, and so will the producers who use crude oil as an input within that country. As the costs of production rise, profits will fall and producers will supply less, shifting the SRAS curve to the left.

#### Productivity

Changes in productivity can also cause a supply shock. Productivity is defined as output per hour worked. When productivity increases, that means there are more units of output over which to spread out production costs, so unit production costs decline. This leads to an increase in profits, which spurs producers to produce more at any given aggregate price level, and the SRAS curve shifts to the right. Anything that reduces productivity, like aging equipment, would shift the SRAS curve to the left.

#### Technology

Changes in technology can certainly cause a supply shock. A new, faster, more efficient machine, for example, can increase productivity, thereby boosting profits and increasing supply. In addition, technological advances allow companies to offer new products and services that may be in great demand, which would push supply higher. Rarely do technological changes reduce productivity, so technological changes are usually considered a factor that induces positive supply shocks.

#### Taxes, Subsidies, and Regulations

Taxes, subsidies, and regulations can also cause supply shocks. Higher business taxes would reduce profits and cause a decline in aggregate supply. A subsidy to produce a product that currently has little demand but would be beneficial for society would offset some production costs and increase aggregate supply. Stringent regulations on businesses would lead to higher production costs if they increased paperwork or led to a delay in production to make sure all laws and regulations are being followed before going forward, which would lead to a decline in supply.

#### Expected Changes in the Price Level

If producers expect the prices of inputs to rise in the future, they will pull back on production. For example, if inflation is rising, employees are likely to ask for higher wages. If it is likely that producers will have to do so in order to keep their staff, unit production costs are likely to rise, and profits are likely to fall. If unit profits fall, companies will produce fewer units. Similarly, if input costs, like crude oil, are expected to fall, unit production costs will decline, profits will rise, and companies will produce more of those now more profitable units.

### Effects of Supply Shocks

Now that we know the causes of supply shocks, what are the effects?

#### Effects of a Negative Supply Shock

When something happens that causes production costs to increase and profits to decline, aggregate supply goes down.

For example, if oil prices rise, many companies that use oil as an input will pull back on production. When this happens, the SRAS curve shifts to the left, and the aggregate price level increases. Since output has slowed the economy has stagnated, and since prices have risen the economy is experiencing inflation. This combination of stagnation and inflation is known as stagflation, the worst of all economic scenarios. With prices rising, workers will demand higher wages, which pushes production costs and selling prices even higher, which causes workers to demand still higher wages. This cycle of higher prices and higher wages is known as a wage-price spiral. Eventually, as production costs continue to rise, producers will trim their staff, and unemployment increases. A higher unemployment rate will eventually reduce workers' ability to ask for higher wages, and the wage-price spiral ends. However, this comes at the cost of a lot of output and a lot of jobs.

In some cases, the government will step in with legislation, like a tax cut or a stimulus check, to boost aggregate demand. While this will support the economy and employment, it can also lead to higher prices. So while this can help to improve aggregate demand and induce more aggregate supply, it comes at the cost of rising inflation.

#### Effects of a Positive Supply Shock

When something happens that causes production costs to decline and profits to increase, aggregate supply goes up.

Suppose a car manufacturer buys new machines that can produce cars quicker and more efficiently. In this case, unit production costs will go down, profits will go up, and the car manufacturer will produce more cars. This would shift the SRAS curve to the right, and the aggregate price level would go down. As the aggregate price level declines, aggregate demand increases, which leads to more output and more jobs. If demand and employment rise enough, workers will have more leverage to ask for higher wages. However, since producer profits are rising, as opposed to falling under stagflation, producers will be more willing to grant those higher wages to workers. This is the best of all economic scenarios. Producers are making good profits, more people are working, and workers are receiving higher wages.

## Supply shock example

Let's take a look at a supply shock example.

### Negative Supply Shock Example

One supply shock example is the oil price shock of the early 1970s.

The Organization of Petroleum Exporting Countries, known as OPEC, decided to curtail the production of crude oil to raise prices. In the period between 1973 and 1975, the price of crude oil nearly tripled from $23.81 in July 1973 to$63.46 in February 1974 due to OPEC's actions.1 As a result, the U.S. economy entered into recession, with the inflation rate rising from 3.6% in January 1973 to 12.2% in November 1974,5 the unemployment rate rising from 4.9% in 1973 to 8.5% in 1975,3 and productivity growth slumping from 5.8% in the first quarter of 1973 to -2.1% in the second quarter of 1974.6

A few years later, it happened again. OPEC reduced crude oil production and crude oil importing countries once again found themselves in recession. In the U.S., the price of crude oil more than doubled from $64.98 in December 1978 to$143.07 in May 1980,1 inflation rose from 6.2% in February 1978 to 14.6% in March 1980,5 the unemployment rate jumped from 5.2% in May 1979 to 11.4% in January 1983,3 and productivity growth fell from 1.8% in the first quarter of 1979 to -1.8% in the first quarter of 1982.6 The result was a 1.8% decline in real GDP in 1982,4 as can be seen in Figure 3 below.

Fig. 3 - U.S. Real GDP Growth

### Positive Supply Shock Example

Another supply shock example is the late 1990s in the U.S.

Thanks to new inventions like the personal computer and the internet, productivity growth exploded from 0.6% in the first quarter of 1995 to 4.2% in the fourth quarter of 1999,6 pushing companies to produce more, and the stock market soared.7 The result was a near doubling of real GDP growth from 2.7% in 1995 to 4.8% in 1999,4 as seen in Figure 3 above, a decline in inflation from 3.4% in December 1996 to 1.4% in February 1998,5 and a decline in the unemployment rate from 6.2% in January 1995 to just 3.6% in October 2000.3 After slowing slightly in 2000, real GDP growth plunged from 4.1% in 2000 to just 1.0% in 20014 as the internet boom turned into a bust and the stock market crashed.7 While many tech companies went out of business, a few survived and have become the backbone of the U.S. economy, stock market, and society of today.

## Supply shock recession

An example of a supply shock recession was in 1981-1982.

Only a few years after OPEC decreased crude oil production in 1973, they did it again in 1978. This pushed up production costs for many companies across the U.S. economy, which resulted in a decline in aggregate supply, represented by a leftward shift of the SRAS curve as seen in Figure 4 below (from SRAS1 to SRAS2). With production and supply down, this led to an increase in the aggregate price level2 (from PL1 to PL2) as well as an increase in the unemployment rate.3 This stagnation of output and inflation of prices is known as stagflation, the worst of all economic scenarios.

Fig. 4 - Negative Supply Shock

## Supply shock graph

The supply shock graph below shows the effects of a positive supply shock. An increase in productivity or an increase in employment can lead to higher production levels, which is represented by a rightward shift of the SRAS curve, as seen in Figure 5 below. The result is higher output, lower unemployment, and a lower aggregate price level. This is what happened in the late 1990s in the U.S. The inventions of the personal computer and the internet dramatically improved productivity,6 and the economy found itself in the sweet spot for several years, with real GDP growth exceeding 4.0% from 1997 to 2000,4 before everything came to a screeching halt in early 2001 as the tech bubble burst.7

Fig. 5 - Positive Supply Shock

## Beneficial supply shock

A beneficial supply shock is one where output suddenly increases, usually driven by an increase in productivity, but can also be driven by a reduction in input costs. An example of a beneficial supply shock was in 1986, when OPEC members fought amongst themselves about whether or not to reduce crude oil production. They decided not to reduce production, which led to a decline in crude oil prices by almost half from $55.83 in July 1987 to$33.06 in September 1988.1 This greatly reduced production costs for U.S. companies, resulting in an increase in aggregate supply, represented by a rightward shift of the SRAS curve. Output increased, from 3.5% in 1986 to 4.2% in 1988,4 the unemployment rate declined from 7.2% in June 1986 to 5.0% in March 1989,3 and inflation slowed dramatically from 4.0% in January 1986 to just 1.2% in December 1986.

## Supply Shock - Key takeaways

• A supply shock is an unexpected rapid increase or decrease in aggregate supply at any given aggregate price level.
• Causes of supply shocks include changes in input prices, changes in productivity, changes in technology, changes in taxes, subsidies, and regulations, and expected changes in the aggregate price level.
• The effects of a negative supply shock are lower output, lower employment, and higher prices.
• The effects of a positive supply shock are higher output, higher employment, and lower prices.
• An example of a negative supply shock is the oil price shock of the early 1970s. An example of a positive supply shock is the technological revolution of the late 1990s.

## References

1. Macrotrends, Oil Price https://www.macrotrends.net/1369/crude-oil-price-history-chart
2. U.S. Bureau of Labor Statistics, Inflation Rate https://www.bls.gov/data/home.htm
3. U.S. Bureau of Labor Statistics, Unemployment Rate https://www.bls.gov/data/home.htm
4. U.S. Bureau of Economic Analysis, Table 1.1.1 https://apps.bea.gov/iTable/iTable.cfm?reqid=19&step=2#reqid=19&step=2&isuri=1&1921=survey
5. U.S. Bureau of Labor Statistics, All Urban Consumers Price Index https://www.bls.gov/data/home.htm
6. U.S. Bureau of Labor Statistics, Productivity https://www.bls.gov/data/home.htm
7. Macrotrends, Dow Jones Industrial Average https://www.macrotrends.net/1319/dow-jones-100-year-historical-chart

An example of a negative supply shock was the oil price shock in the early 1970s. An example of a positive supply shock was the technological revolution of the late 1990s.

A negative supply shock increases inflation, while a positive supply shock reduces inflation.

The difference between a supply shock and a demand shock is that a supply shock affects the amount of goods and services produced, whereas a demand shock affects the amount of goods and services consumed.

A supply shock is an unexpected rapid increase or decrease in aggregate supply at any given aggregate price level.

A negative supply shock can be fixed with lower interest rates, lower tax rates, or increased government spending. A positive supply shock does not need to be fixed because it is a good thing for the economy, bringing more output, more jobs, and lower prices.

## Final Supply Shock Quiz

Question

Define a supply shock.

A supply shock is an unexpected rapid increase or decrease in aggregate supply at any given aggregate price level.

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Question

Which of the following is a cause of a supply shock?

Input Prices

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Question

Higher input prices can cause a _____ supply shock.

Negative

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Question

Higher productivity can cause a _____ supply shock.

Positive

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Question

A change in technology almost always causes a _____ supply shock.

Positive

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Question

Higher corporate taxes can cause a _____ supply shock.

Negative

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Question

Corporate subsidies can cause a _____ supply shock.

Positive

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Question

Stronger regulations can cause a _____ supply shock.

Negative

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Question

A higher expected price level can cause a _____ supply shock.

Negative

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Question

The effects of a negative supply shock are _____ output and a _____ aggregate price level.

lower, higher

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Question

The effects of a positive supply shock are _____ output and a _____ aggregate price level.

higher, lower

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Question

The OPEC oil embargo of the early 1970s is an example of a _____ supply shock.

Negative

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Question

The technological revolution of the late 1990s is an example of a _____ supply shock.

Positive

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