Extra Credit (Spring 2007)

High school activity (Grades 9–12)

Content standards: National Council on Economic Education Standards 7, 8, 16, and 19

Supply Shocks: For Better or Worse
50–90 minutes

Students will learn the impact of supply shocks on prices and output. The market for oil and gasoline serves as an illustration of the impact of supply shocks.

The dependency of the U.S. economy on energy creates an uneasy alliance. Access to energy contributes to the United States' high standard of living and makes the nation more productive, but not without a cost.

What lessons can be learned from the effects of the 2005's Gulf Coast storms? Their impact highlighted the nation's vulnerability to increased energy prices when supply is restricted. High energy prices can affect consumers by causing them to pay more to heat their homes, drive a car, or even travel in a plane. High energy prices can cause businesses to pass on the increase in their transportation and energy costs to their customers, including the consumer. As a result, inflation can increase and economic growth can fall.

Related Links
PowerPoint presentation

Perhaps the impact of 2005's supply shock has implications for future energy policy decisions. As individuals, we can take actions to minimize the effect of the shocks on our budgets. Consumers might be more inclined to conserve gas and energy or substitute towards goods and services that use energy more efficiently, such as hybrid vehicles or public transportation. The private sector may contribute to the research and development of alternative and renewable energy sources if such research and development are profitable. The public sector may provide tax incentives for energy conservation. With time and ingenuity, the United States economy's dependency on oil may decrease, mitigating the adverse effects of energy supply shocks.

1. As a warm-up, ask students if and how they were affected by Hurricane Katrina or what they remember about it. Ask students how people who did not actually experience Hurricane Katrina might have been affected financially. Suggest to students that many people were affected by an increase in energy costs, especially gasoline because Hurricanes Katrina, Rita, and Wilma upset the supply of gasoline and led to higher prices at the pump.
2. Tell students that the high prices people experienced during the 2005 hurricanes were the result of a supply shock, and share the definition with them.

Chart 1: A Supply Shock
Chart 1: Supply side
Source: Wall Street Journal
For teacher's reference
A supply shock is an event that suddenly changes the price of a commodity or service and may be caused by a sudden change in the supply of a particular good. This sudden change affects the equilibrium price.

A negative supply shock (sudden supply decrease) shifts the aggregate supply curve to the left, producing both a reduction in the quantity sold and an increase in the commodity price. A negative supply shock can cause stagflation (inflation and negative growth) because of a combination of rising prices and falling output.

An increase in supply will shift the aggregate supply curve to the right and lower the price of a good. A positive supply shock is unlikely, especially in the energy market, because very few events would cause oil to be brought to market quickly enough to represent a shock. An increase in supply could be the result of an advance in technology that makes production more efficient, thus increasing output over time.

3. Have students graph a negative supply shock, reflected by a leftward shift, or decrease, in aggregate supply on an aggregate demand and aggregate supply graph. Explain that Hurricanes Katrina, Rita, and Wilma in 2005 upset the production and supply of gasoline, causing a negative supply shock with a price increase and an output decrease. The hurricanes damaged U.S. oil production, refinery, and distribution from the Gulf of Mexico.
4. Have students draw an increase in supply on a graph. Ask for examples of a supply increase caused by improvements in technology that can lower energy prices. (For example, improved technology in the production of ethanol may eventually lead to its widespread use to fuel cars.)
5. Optional: Show students the slides from the accompanying PowerPoint presentation, "Effects of Supply Shocks on U.S. Energy Prices." The slides are adapted from a presentation by Ellis W. Tallman, vice president, macropolicy team, Federal Reserve Bank of Atlanta.
6. Explain to students that supply shocks have often been caused by political events in addition to geographic events like hurricanes. Tell students they will investigate several historical political events that caused supply shocks. (If you completed the optional step 5, return to the presentation's slide 3 as a reference, showing world oil price fluctuations since the 1970s.)
7. Put students into groups to investigate the events surrounding the following supply shocks, including the causes of, and responses to, the supply shock they are assigned. Students should find out the "who, what, when, where, why, and how" of their assigned supply shock. They can use their history books, the Internet and computer, and the library or conduct interviews to obtain information on their assigned event. Have them report their findings to the class.
Political Event
Group 1 October 1973 Yom Kippur War/Arab Oil Embargo
Group 2 October 1978 Iranian Revolution
Group 3 September 1980 Iran-Iraq War
Group 4 August 1990 Persian Gulf War
Group 5 December 2002 Civil Unrest in Venezuela
Group 6 March 2003 Iraq War
8. As an assessment, ask students to prepare an answer to the following prompt:

"What can the U.S. government do to lessen the impact of gasoline and oil supply shocks on the U.S. economy? What can you personally do to lessen the impact of gasoline and supply shocks on your own pocketbook?"

You might consider having students write an essay, develop a presentation, or create a song or other product to answer the prompt.


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