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What Is Cost-Push Inflation?
Cost-push inflation occurs when overall prices increase (inflation) due to increases in the cost of wages and raw materials. Higher costs of production can decrease the aggregate supply (the amount of total production) in the economy. Since the demand for goods hasn’t changed, the price increases from production are passed onto consumers creating cost-push inflation.
Understanding Cost-Push Inflation
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.
Inflation is a measure of the rate of price increases in an economy for a basket of selected goods and services.
Inflation can erode a consumer’s purchasing power if wages haven’t increased enough or kept up with rising prices.
If a company’s production costs rise,
the company’s executive management might try to pass the additional costs onto consumers
by raising the prices for their products.
If the company doesn’t raise prices, while production costs increase, the company’s profits will decrease.
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Cost push inflation
An increase in the price level due to an increase in production costs e.g. taxes, wages, utility or component prices. The cost increase will cause a negative shift in the SRAS curve. This causes prices to rise as costs push the supply curve up the aggregate demand curve.
Below is a diagram to show the impact of production costs rising over time, leading to a period of stagflation for the economy (inflation and negative growth). Generally it is any increase in factor of production cost that instigates the inward SRAS curve shift (increase in wages or higher prices for commodities such as oil). But there are also outside influences that could create this curve shift as well e.g. external inflation and higher taxes.
The factors that would create this type of inflationary pressure are:
- Increases in labour costs
- or Increases in price of raw materials/commodities
- Increases in the cost of imports (weaker currency)
- or Increases in the cost of capital
Because this type of inflation is brought about by production cost changes and not a stimulation in economic activity, it is perceived as the worst form of inflation an economy can experience when compared to consumption driven or investment driven inflation (demand pull inflation). This is because unlike with demand pull inflation, there is no opportunity for the LRAS curve to expand in the long-run to create disinflationary growth and return the economy back to full employment.
Cost push inflation changes in the price level
Cost push inflation can also lead to more severe changes in the price level if it is part of an inflationary spiral as shown below. This is created originally because of an increase in production costs moving the economy below the full employment and moving the economy to point B, as before. However, the rising costs of production can boost the disposable incomes of the owners of the factors of production (particularly if brought about by higher wages) which can result in an increase in spending and economic activity assuming ceteris paribus (depending on the marginal propensity to consume and save).
This causes the AD curve to expand and moves the economy back to the full employment output level. Crucially though, this leads to further inflationary pressures as the price level has now increased to P3.
The spiral can then continue because if prices in the economy are increasing quickly,
workers will bargain for higher wages to ensure in real terms they are made no worse off.
This further increase in production costs for firms forces the SRAS curve inwards once again
and a new macroeconomic equilibrium is settled at point D, stoking inflationary pressures even higher (P4).
This process can continue and introduce crippling high inflation rates for a country.
Cost-Push vs. Demand-Pull
Rising prices caused by consumers 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 onto consumers.
Example of Cost-Push Inflation
The Organization of the Petroleum Exporting Countries (OPEC) is a cartel that consists of 13 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.1
What followed was a supply shock and a quadrupling of the price of oil from approximately $3 to $12 per barrel.2 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.