## Demand Side Shocks

#### The Demand Relationship

The demand equation may be written using the following general functional form:

Qd = f(Px; Income, Preferences, Py, # of consumers),

where 'Px' represents the "own" price of the good demanded. The variables listed after the semi-colon represent other exogenous variables that affect the quantity demanded for a particular good. 'Py' in this list represents the price of a related good (substitutes or complements).

#### Exogenous Shocks

Changes in own price (due to surpluses or shortages) will lead to a movement along the demand curve. In contrast changes in any of the exogenous variables will lead to an inward or outward shift in demand. Any shock that leads to an outward shift in demand (holding the supply of that good constant) will create a shortage of that good at prevailing market prices. This shortage leads to an increase in market prices with corresponding movements along the demand and supply equations until a new equilibrium price and quantity are established.

#### Example: Market for Personal Computers

Before After

We can examine this type of shock in the diagram to the right. The market in this example will be for personal computers (assumed to be a normal good). The exogenous shock will be an increase in consumer income. Given this shock, consumers will attempt to purchase more personal computers at each and every price. This reaction will lead to a shortage of this good and thus an increase in the market price. As the market price rises, consumers reduce their rate of consumption (a decrease in quantity demanded) along the new demand schedule and producers increase the rate of production (an increase in quantity supplied).The net result will be an increase of both equilibrium price and quantity.

Shocks that lead to an inward shift will have the opposite effect (creates a surplus which leads to a reduction in market price) as shown in the example below:

#### Example: Market for Automobiles

Before After

We can examine this type of shock in the diagram to the left. The market in this example will be for automobiles (assumed to be a complement with gasoline. The exogenous shock will be an increase in the price of gasoline. Given this shock, consumers will drive less and begin to purchase fewer autos at each and every price. This reaction will lead to a surplus of this good and thus a decrease in the market price. As the market price falls, consumers increase their rate of consumption (an increase in quantity demanded) along the new demand schedule and producers reduce the rate of production (a reduction in quantity supplied). The net result will be a decrease of both equilibrium price and quantity.

Shifts in demand (resulting from changes in any of the exogenous variables) and the impact on equilibrium price and quantity is demonstrated in the diagram below (just move the mouse-pointer over any of the blue spheres to see changes):

 Exogenous shock Income:normal good Preferences:(stronger) Price of a:substitute Price of a:complement # of Buyers(Consumers)