What Is Cost-Push Inflation?

What Is Cost-Push Inflation?

Cost-push inflation happens when businesses raise the price of goods and services because the cost of producing them increases. Imagine you run a lemonade stand and the cost of lemons, sugar, and water goes up from last month. To keep making a profit, you have to pass that increase on to your customers. That's cost-push inflation. It can also come from higher wages, taxes, supply-chain issues, or when higher costs decrease the aggregate supply in the economy.

Key Takeaways

Cost-push inflation happens when prices increase due to rises in the cost of wages and raw materials. It can also occur when higher production costs decrease the aggregate supply. Businesses pass on these increased production costs to consumers by raising their prices.

Understanding Cost-Push Inflation

Inflation measures the rate of price increases in an economy for a basket of selected goods and services. It can erode your purchasing power if wages haven't increased enough or kept up with rising prices. If a company's production costs rise, the executive management might try to pass those additional costs on to consumers by raising product prices. If the company doesn't raise prices while production costs increase, their profits will decrease.

The most common cause of cost-push inflation starts with an increase in the cost of production, which may be expected or unexpected. For example, the cost of raw materials or inventory used in production might increase, leading to higher costs. For cost-push inflation to take place, demand for the affected product must remain constant during the time the production cost changes are occurring. To compensate for the increased cost of production, producers raise the price to the consumer to maintain profit levels while keeping pace with expected demand.

Causes of Cost-Push Inflation

As I mentioned, an increase in the cost of input goods used in manufacturing, such as raw materials, is a cause of cost-push inflation. For example, if companies use copper in the manufacturing process and the price of the metal suddenly rises, companies might pass those increased costs on to their customers.

Increased labor costs can create cost-push inflation, such as when mandatory wage increases for production employees due to a rise in the minimum wage per worker. A worker strike due to stalled contract negotiations might also lead to a decline in production and, as a result, higher prices.

Unexpected causes of cost-push inflation are often natural disasters, which can include floods, earthquakes, fires, or tornadoes. If a large disaster causes unexpected damage to a production facility and results in a shutdown or partial disruption of the production chain, higher production costs are likely to follow. A company might have no choice but to increase prices to help recoup some of the losses from a disaster. However, not all natural disasters result in higher production costs and therefore wouldn't lead to cost-push inflation.

Other events might qualify if they lead to higher production costs, such as a sudden change in government that affects the country's ability to maintain its previous output. However, government-induced increases in production costs are more often seen in developing nations.

Government regulations and changes in current laws, although usually anticipated, may cause costs to rise for businesses because they have no way to compensate for the increased costs associated with them. For example, the government might mandate that healthcare be provided, driving up the cost of employees or labor.

Cost-Push vs. Demand-Pull

Rising prices caused by consumers wanting more goods is called demand-pull inflation. Demand-pull inflation includes times when an increase in demand is so great that production can't keep up, which typically results in higher prices. In short, cost-push inflation is driven by supply costs while demand-pull inflation is driven by consumer demand—while both lead to higher prices passed on to consumers.

Example of Cost-Push Inflation

The Organization of the Petroleum Exporting Countries (OPEC) is a cartel that consists of 12 member countries that both produce and export oil. In the early 1970s, due to geopolitical events, OPEC imposed an oil embargo on the United States and other countries. OPEC banned oil exports to targeted countries and also imposed oil production cuts.

What followed was a supply shock and a quadrupling of the price of oil from approximately $3 to $12 per barrel. Cost-push inflation ensued since there was no increase in demand for the commodity. The impact of the supply cut led to a surge in gas prices as well as higher production costs for companies that used petroleum products.

What Causes Inflation?

Inflation, or a general rise in prices, is thought to occur for several reasons, and the exact reasons are still debated by economists. Monetarist theories suggest that the money supply is the root of inflation, where more money in an economy leads to higher prices. Cost-push inflation theorizes that as costs to producers increase from things like rising wages, these higher costs are passed on to consumers. Demand-pull inflation takes the position that prices rise when aggregate demand exceeds the supply of available goods for sustained periods of time.

Is Inflation Always Bad?

In theory, a low amount of inflation can be a healthy sign of a growing economy. High inflation, however, can be damaging (but deflation, or declining prices, can be as well). Note that inflation isn't always bad for certain groups of people. For example, borrowers at fixed interest rates tend to benefit from inflation, while lenders and savers are hurt by it.

What Is the Wage-Price Spiral?

The wage-price spiral, a take on cost-push inflation, occurs when wages rise, creating more demand, which leads to higher prices. These higher prices thus incentivize workers to demand even higher wages, and so the cycle repeats.

The Bottom Line

Cost-push inflation occurs when overall prices increase due to increases in the cost of wages and raw materials. It can also occur when higher costs of production decrease the aggregate supply in the economy. When production falls while demand for goods remains unchanged, price increases from production are passed on to consumers, creating cost-push inflation.