Supply Shock

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.

Effects of a Positive Supply Shock

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

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.

Fig. 3 - U.S. Real GDP Growth

Positive Supply Shock Example

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

Supply Shock Recession

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

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.