Shocks – Size and Elasticity

We can do one more thing before we wrap up this module. Let’s revisit market shocks and evaluate the expected changes to revenue, consumer and producer surplus, and total value given our new knowledge of elasticity.

Figure 7-14: Demand shocks to markets with different supply elasticity. Permission: Courtesy of course author Hayley Hesseln, Department of Agriculture and Resource Economics, University of Saskatchewan.

Assume there is a shock to demand for a product with high elasticity of supply (first panel in Figure 7-14), and the same shock to demand occurs for a product with low supply elasticity. The Demand curve shifts to the right (it’s the new red demand curve D1 in both panels). You can see the very small change in price relative to the change in quantity in the first panel. Price hardly changes at all, while there is a much higher change to quantity.

Do you think it’s weird that price went up and quantity demand also went up? Here’s a perfect example of where it’s important to understand the difference between “change in demand” and “change in quantity demanded.” The first thing that happened was a shift in the demand curve (say preferences increased for the product). Because the supply is relatively elastic, the resulting effect is a movement along the supply curve and an increase in quantity supplied/demanded. The percentage change in quantity supplied is greater than the percentage change in price meaning supply is relatively elastic.

In the second panel, the same shock to demand results in a much different market outcome. The change in price is relatively greater than the change in quantity. This supply curve is relatively inelastic compared to the one in the first panel meaning that suppliers do not respond greatly to a change in price.

The interesting part is to figure out why? Perhaps it’s the short term, and the producer is John Deere for example, and cannot increase capacity regardless of price. The first panel might represent a supplier of fertilizer that has large stores that are available to go to market at any time, thus making the producer much more flexible, or responsive.

The final example looks at the same market but shows you a vastly different result based on the size of the shock.

Figure 7-15: Size of shocks matter. Permission: Courtesy of course author Hayley Hesseln, Department of Agriculture and Resource Economics, University of Saskatchewan.

Figure 7-15 shows two shocks, one to supply and one to demand. To keep things relatively clear, I’ve made the shock to supply the same size. In both panels, there is a positive shock to demand (the demand curve shifts from D to D1). In both panels, there is a negative shock to supply – assume bad weather and ruined crops. The supply in both panels falls from S to S1. In both cases, the initial equilibrium occurs at the intersection of the blue lines, and the new market equilibrium occurs at the intersection of the red lines.

What’s the difference between panels? In the first panel, the shift of the supply curve is relatively small compared to that of the second panel. Demand increases in both, but not nearly as much. The result for the first panel is an increase in price, and a decrease in quantity demanded. However, the result for the second panel is an increase in price, and an increase in quantity demanded. I could have made the shock such that there wasn’t a change in quantity demanded as well. So, in this case, with the limited information we have, we can only be sure that there is an increase in price. Without knowing the size of the demand shock, we can’t be sure what will happen to the quantity demanded/supplied. This ladies and gentlemen, is why economists never agree. As the old joke goes, ask three economists their opinion and you will get four answers.

To actually estimate the changes in price and quantity and the effects of such changes we would have to have more information about supply and demand elasticity and the size of the shocks that occurred. Those types of things will be the subjects of future economics classes after I convince you all that economics is absolutely fascinating (if I haven’t already).