1 - How Supply Shocks Arise and Why Political Responses to Them Vary

Summary

A simple Cobb-Douglas production function illustrates how supply shocks affect relative returns and, thereby, a society’s degree of economic inequality, whether measured as the rental-wage ratio, the share of income going to the top few percentiles of the distribution, or the Gini coefficient. Illustrative examples of positive and negative shocks to the supply of labor, land, physical capital, and human capital are presented and their main causes adduced. Trade also matters. An unanticipated opening or closing of trade routes can effectively change a factor’s supply or the availability of external markets for products that use that factor intensively. Unforeseen innovations in transportation and communication, or the discovery of new trade routes, open new sources and markets; wartime blockades often close them. Both historically have given rise to extreme supply shocks.