Macroeconomics a Supply Shock Is

Macroeconomics A supply shock is "an unexpected event that changes the supply of a product or commodity, resulting in a sudden change of its price" (Investopedia, 2011). A supply shock can either be positive or negative, although the term is more commonly understood to be negative. The shock is the sudden and significant change in supply, and the result of this is that the market must make an adjustment. Typically, when supply of a good is constrained, the price is going to rise. Other times, demand simply goes unfulfilled.

An example of a supply shock that leaves unfulfilled demand occurred this past year with Toyota vehicles. The tsunami affected a number of Toyota's parts suppliers, with the result being that the company did not have sufficient parts to maintain production levels. As a result of that, Toyota was forced to halt production. The company was forced to maintain prices despite the shortage as a result of its competitive position, but demand for some products the company was simply unable to meet (CNN, 2011).

An example of a negative supply shock was the oil crisis in the 1970s, when the supply of oil was reduced and the price skyrocketed as a result. Two other types of supply shocks are beneficial supply shocks and adverse supply shocks. A beneficial supply shock is when there is an increase in output, which decreases the price level (McEachern, 2011). For a supply shock to be considered as a beneficial supply shock, the change in output must be permanent.

An example of this would be the use of new technology to permanently increase productivity in an industry. Another example would be a major new player entering the market. The beneficial supply shock will typically create overcapacity in the industry, which lowers the price. Over time, the industry is likely to return on an equilibrium position, but this will be at the new price level. An adverse supply shock would be the opposite.

The above Toyota example is a temporary supply shock, one from which the company has probably recovered at this point. But an adverse supply shock is more permanent in nature. Aggregate supply decreases permanently, and this increased scarcity is reflected in higher prices. For the shock to be permanent, there must be barriers to firms increasing production. If the firms in the industry were able to increase production in order to meet the new high price the good would simply return to a state of equilibrium.

Instead, something must constrain the ability of firms in the industry to respond in that way. If a key input becomes scarce, that would be an example of an adverse supply shock. Often, this involves the depletion of a key natural resource. Over time the market may adjust to the adverse supply shock in any number of different ways. For example, consumers may respond to the higher price by lowering their consumption. The oil crisis in the 1970s resulted in small cars becoming more popular, decreasing per capita oil.