Supply shock

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Definition

A supply shock is a sudden shift in the supply curve for a good, service, or commodity, leading to a change both in the market price and in the quantity of the commodity being traded. Supply shocks are of two types:

  • Positive supply shock: A sudden increase in the supply at every price. In other words, a sudden rightward shift of the supply curve. A positive supply shock leads to a sudden excess supply of the commodity, which, if the market is fast to respond, leads to a reduction in price and an increase in the quantity traded.
  • Negative supply shock: A sudden decrease in the supply at every price. In other words, a sudden leftward shift of the supply curve. A negative supply shock leads to sudden scarcity, or excess demand. If markets adjust fast enough, this leads to an increase in price and a decrease in the quantity traded.

Supply shocks differ from more gradual changes in the supply curve largely in terms of their suddenness, which may lead to inadequate market response and periods of panic. Supply shocks (particularly negative ones) for commodities crucial to an economy may even lead to economic recessions.

Causes for supply shock

Structural changes in the industry

These structural changes are most likely to be responsible for supply shocks in industries with a few large players:

  • One or more of the major firms involved in producing the commodity goes bankrupt, or there is an accident that renders it unable to provide the commodity. This causes a negative supply shock. Conversely, if a new firm enters an industry, it may result in a significant increase in production in that industry, causing a positive supply shock.
  • Some of the firms involved in producing the commodity get together and form a powerful cartel, allowing them to raise prices significantly with their new-found market power. This is particularly true in markets that are oligopolistic to begin with. Examples are natural resources such as oil, where cartelization of oil suppliers can significantly impact oil supply and price, as happed with the empowerment of OPEC in the 1970s. This causes a negative supply shock. Conversely, if a new firm enters a small cartelized or oligopolistic industry, or an existing cartel breaks down, there is a sudden downward price war and a positive supply shock.

Changes in regulation

Closely related to structural changes in the industry are changes in the legal and regulatory framework. For instance:

  • The removal of certain barriers to entry may lead to a large number of new entrants into an industry, causing a lot of competition and an increase in supply, i.e., a positive supply shock. Note that if it takes a long time for new industries to become operational, the changes in supply may be less sudden.
  • The removal of trade barriers or reduction of tariffs, that increases the base for competition. This may again lead to a positive supply shock.

Changes in technology

Technological change usually leads to positive supply shocks, since technology in general improves rather than deteriorates. In general, technological change may dramatically lower the costs to sellers of production, distribution, and reaching buyers, and it may also reduce costs to buyers of reaching sellers. This increases supply in two ways: existing suppliers produce more, and more new suppliers may enter.