What Is a Demand Shock?

A demand shock is a sudden and surprise event that dramatically increases or decreases demand for particular goods or services, usually on a temporary basis. A positive demand shock is a sudden increase in demand, while a negative demand shock is a decrease in demand. Both a positive demand shock and a negative demand shock will have an effect on the prices of goods and services.

Demand shocks may be contrasted with supply shocks, where there is a sudden decrease or increase in the supply of a good or service that causes an observable economic effect; both supply and demand shocks are forms of economic shocks.

Key Takeaways

  • A demand shock is a sharp, sudden change in the demand for particular goods or services.
  • A positive demand shock will cause the price of goods to skyrocket and lead to limited supply, while a negative shock will cause prices to collapse and lead to an oversupply.
  • Demand shocks are often temporary disruptions, that the market will adjust to eventually by incentivizing more production of supply in a positive shock, or else the bankruptcy of producers in a negative shock.

Understanding Demand Shocks

A demand shock is a large but transitory disruption of market prices caused by an unexpected event that changes the perception and level of demand with regard to a specific good or service, or a group of such goods or services. Earthquakes, terrorist events, technological advances, and government stimulus programs are all examples of events that can cause demand shocks.

When the demand for a good or service rapidly increases, the price of that good or service typically increases because suppliers cannot cope with the increased demand given the current level of supply capacity. In economic terms, this results in a shift in the demand curve to the right. A sudden drop in demand causes the opposite to happen since the supply will remain too elevated over the decreased demand until capacity can be attenuated.

A positive demand shock can come from fiscal policy, such as an economic stimulus or tax cuts. Other demand shocks can come from the anticipation of a natural disaster, such as buying bottled water or gasoline before a hurricane. Negative demand shocks can come from contractionary policy, such as tightening the money supply or decreasing government spending.

Example of a Demand Shock

The rise of electric cars over the past few years is a real-world example of a demand shock. It was hard to predict the demand for electric cars and, therefore, their component parts. Lithium batteries, for example, had low demand as recently as the mid-2000s.

From 2010, however, the rise in the demand for electric cars from companies like Tesla Motors increased the overall market share of these cars to 3 percent, equal to roughly 2,100,000 vehicles. This meant that the demand for the lithium batteries that power these cars also increased sharply, and somewhat unexpectedly. Lithium is a limited natural resource that is difficult to extract and found only in limited parts of the world. Therefore, production has been unable to keep up with the growing demand, and so the supply of newly mined lithium remains lower than it would be otherwise. The result is a demand shock.

Over the period from 2004 to 2014, the demand for lithium more than doubled, increasing the price per metric ton from $5,180 in 2011 to $6,600 in 2014. Because the demand for electric vehicles and other uses of batteries, such as mobile phones and tablets, has exploded since 2014, the price of lithium has more than doubled again, to $16,500 per metric ton in 2018. This increase in demand for electric cars increased the cost of component parts, and these rising costs are being passed onto the consumer, raising the cost of electric cars in a positive demand shock environment.

An example of a negative demand shock would be a product that becomes technologically obsolete, such as cathode ray tubes. The introduction of low-cost flat-screen televisions caused the demand for cathode-ray tube TVs and computer screens to drop to nearly zero in only a few short years.