What is supply shock?

A supply shock is a sudden change in the availability of a product, commodity, or service, leading to price fluctuations. Supply shocks can be due to temporary supply disruptions, like a blocked shipping route, or longer-term issues, such as a war or trade embargo.

Supply shocks can be either negative or positive. Negative supply shocks drive prices up by reducing supply, while positive shocks increase supply and lower prices.

Why do supply shocks occur?

Supply shocks happen when an unexpected event disrupts the availability of a good or commodity, causing prices to shift. These shocks can be negative – such as those created by natural disasters, trade embargoes, or war – or positive, like technological breakthroughs or new manufacturing methods that increase supply and reduce costs.

Economists believe supply shocks occur due to sudden shifts in expected output, which forces prices to adjust to a new equilibrium. While negative shocks often lead to higher costs and economic strain, positive shocks can improve efficiency and raise living standards. Over time, supply shocks may resolve naturally or through corporate action.

What is a positive supply shock?

A positive supply shock increases the availability of a product or reduces production costs, often leading to lower prices and economic expansion. This type of shock shifts the short-run aggregate supply (SRAS) curve to the right, helping control inflation and stimulate growth.

Positive supply shocks may be caused by:

• Technological advancements: Breakthroughs in manufacturing, automation, or energy efficiency can lower production costs and create a positive supply shock. For example, Henry Ford’s introduction of the assembly line revolutionized car manufacturing by reducing production time and costs.
• Resource discoveries: Finding new sources of raw materials can increase supply and reduce costs. For example, discovering vast natural gas reserves can help reduce energy costs for both consumers and industries.
• Bumper harvests: High agricultural yields increase food supply and drive prices down. For example, a record-breaking corn harvest creates an oversupply that can make corn-based products cheaper.
• Improved trade policies: Removing tariffs or trade barriers can increase supply by making imported goods more accessible. For example, a free trade agreement allows more goods to flow into a country, which can reduce shortages and lower prices.

Positive supply shocks are generally marked by:

• Increased supply of goods and services
• Lower production costs and consumer prices
• Higher economic output and improved living standards
• Reduced inflationary pressure

However, not all positive supply shocks are purely beneficial. For example, rapid monetary expansion can create short-term economic benefits but may lead to inflation over time.

What are negative supply shocks?

Negative supply shocks reduce the availability of goods, increase production costs, and lead to higher prices. As prices increase, consumer spending may decline, resulting in lower aggregate demand which can further slow economic growth.

Negative supply shocks can be caused by:

• Natural disasters: Hurricanes, earthquakes, and droughts can destroy infrastructure and disrupt production, leading to reduced supply. For example, Hurricane Katrina severely disrupted the U.S. oil and gas industry by shutting down refineries and pipelines.
• Geopolitical conflicts: Wars and trade embargoes can limit access to critical resources and create supply shocks. For example, the Russia-Ukraine war caused a major grain supply shock that increased global food prices. 
• Supply chain disruptions: Transportation bottlenecks, labor strikes, or port shutdowns can reduce the availability of goods. For example, the COVID-19 pandemic caused widespread port congestion and labor shortages that led to shipping delays.
• Government policies: Trade restrictions, tariffs, and increased taxes on production can limit supply. For example, China’s export limits on rare earth metals led to a global shortage of essential materials used in electronics, driving up prices.
• Increased production costs: An increase in wages, energy costs, or raw material prices can reduce supply. For example, a sudden spike in oil prices makes commodity transportation and manufacturing more expensive, reducing output.

Negative supply shocks are generally marked by:

• Reduced supply of goods and services
• Higher production costs and consumer prices (price inflation)
• Lower economic output and slower growth
• Job losses, wage inflation, and business closures

The long-term effects depend on whether the shock is temporary or persistent. If the disruption is prolonged, like a war, it can lead to structural economic challenges.

Positive vs negative supply shocks

The table below summarizes the key differences between positive and negative supply shocks:

Supply shock chart

The charts above illustrate the effect of both negative and positive supply shocks. In both charts, equilibrium is marked at point A while output is represented on the X-axis with prices on the Y-axis.

The left chart shows how a negative supply shock shifts the supply curve to the left, from AS1 to AS2. This means that production decreases, leading to a lowered supply of goods. If demand remains steady, this reduction in supply drives price (P) higher.

The right chart illustrates a positive supply shock, where the supply curve shifts to the right from AS1 to AS2. In this case, production increases, leading to increased supply and lower prices.

Example of a positive supply shock

A classic example of a positive supply shock is Henry Ford’s introduction of the assembly line in automobile manufacturing. This technological breakthrough dramatically increased production efficiency, lowering costs and making cars more affordable for consumers.

Before the assembly line, automobiles were built through a slow and expensive process carried out by skilled craftsmen. In 1914, Ford introduced the moving assembly line, which reduced production time for a single car from 12 hours to around 90 minutes.

The increased output allowed for mass production on an unprecedented scale, which lowered the cost of a Ford Model T from $850 in 1908 to $260 by 1925. Ford’s success led to higher wages for workers and boosted employment in related industries like steel, rubber, and oil. The increased availability of affordable cars subsequently transformed the economy by encouraging the infrastructure development and changing how people lived and worked.

Example of a negative supply shock

One of the most well-known supply shocks in modern U.S. history occurred in the oil markets during the 1970s, contributing to a period of stagflation – a combination of stagnant economic growth and high inflation.

In October 1973, the Organization of Arab Petroleum Exporting Countries (OAPEC) imposed an oil embargo on several Western nations, including the U.S. While oil production remained unchanged, the embargo drastically reduced the effective supply of oil available in the U.S., causing a sharp increase in prices. Before the embargo, oil was priced at $2.90 per barrel, and by January 1974 it had surged to $11.65 per barrel.

To counter rising prices, the federal government introduced price controls on oil and gas to stabilize costs for consumers. However, the intervention backfired. By capping prices, it became unprofitable for domestic suppliers to produce oil, which further exacerbated shortages. Meanwhile, the Federal Reserve tried to stimulate the economy with monetary easing, but supply constraints prevented any real increase in output.

This crisis involved multiple negative supply shocks happening in succession:

1. The oil embargo reduced supply, which led to higher prices
2. Government price controls discouraged domestic production, which worsened shortages
3. Monetary policy expansion increased money supply, but without corresponding growth in production, it contributed to inflation.

What is a demand shock?

Demand shocks occur when an unexpected event significantly alters consumer demand for a product or service. These shocks can stem from changing consumer preferences, shifts in income, economic policies, or changes in the prices of related goods (e.g. complements or substitutes). Like supply shocks, demand shocks can be either negative or positive.

Negative demand shocks

A negative demand shock occurs when consumers suddenly reduce their demand for a product, leading to a drop in both price and quantity sold. This can be triggered by factors such as:

• Health or safety concerns: If a medical study links a product to serious health risks, it can drastically reduce demand.
• Economic downturns: Recessions can lead consumers to cut back on non-essential spending.
• Rising prices of complementary goods: If a necessary complement becomes too expensive, demand for the original product may fall.

One recent example is the decline in demand for talcum powder, particularly Johnson & Johnson’s baby powder, following lawsuits and health concerns. This falling demand eventually led to the company discontinuing its talc-based baby powder line.

Positive demand shocks

A positive demand shock happens when an event causes a surge in demand, leading to higher prices and increased consumption. This can be caused by:

• New consumer preferences: Scientific research or trends can increase demand for certain products.
• Rising incomes: When people have more disposable income, they tend to spend more.
• Falling prices of complementary goods: If a complementary product becomes cheaper, demand for the original good may rise.

For example, the COVID-19 pandemic created a positive demand shock for hand sanitizer and other hygiene-related products.

This material is for informational purposes only and should not be considered as an investment recommendation or a personal recommendation.