Overview
Cost-push inflation, also known as wage-push inflation, occurs when overall prices increase due to rises in the cost of wages and raw materials. Higher production costs often lead to a decrease in aggregate supply—the total production in an economy. If the demand for affected goods remains unchanged, price hikes are passed onto consumers, creating cost-push inflation.
Key Insights
- Cost-push inflation arises when rising production costs lead to higher consumer prices.
- It occurs when higher production costs cause a decrease in aggregate supply in the economy.
- When production falls, but demand remains unchanged, increased production costs lead to higher consumer prices.
Understanding Cost-Push Inflation
Inflation measures the rate of price increases in an economy for a selected basket of goods and services. Inflation can erode purchasing power if wages fail to keep pace with rising prices. When a company’s production costs escalate, management may pass these additional costs onto consumers by raising product prices. Failing to do so can jeopardize the company’s profitability.
The common cause of cost-push inflation often begins with expected or unexpected rises in production costs. For instance, increased costs of raw materials or inventory used in production can lead to higher production costs.
For cost-push inflation to happen, the demand for the affected product must stay constant while production costs are rising. To compensate for these rising production costs, producers increase prices for consumers to maintain profit margins.
Causes of Cost-Push Inflation
Numerous factors can lead to cost-push inflation. Here are some prominent causes:
- Increased Cost of Materials: For example, a spike in copper prices can make production more expensive, and these costs are transferred to the consumer.
- Rising Labor Costs: Wage hikes, such as minimum wage increases or contract negotiations, can raise production costs during strikes or labor disputes.
- Natural Disasters: Events like floods, earthquakes, or fires can disrupt production and elevate costs, leading to higher prices.
- Government Actions: Changes in government or new regulations requiring actions like mandatory healthcare can increase business costs without compensation, increasing final product prices.
Comparing Cost-Push and Demand-Pull Inflation
Demand-pull inflation occurs when rising consumer demand increases prices because production capacity cannot keep up. Hence, while cost-push inflation results from rising production costs, demand-pull inflation is driven by increased demand, yet both lead to higher prices for consumers.
Example of Cost-Push Inflation
In the early 1970s, the Organization of the Petroleum Exporting Countries (OPEC) imposed an oil embargo on the United States and other nations due to geopolitical tensions. This embargo caused a significant reduction in the oil supply and quadrupled oil prices from around $3 to $12 per barrel, despite no increase in demand. The resulting higher gasoline and production costs exemplified cost-push inflation.
Understanding Inflation Causes
Inflation, the general rise in prices, can be attributed to various factors, with theories still debated among economists. Monetarist theories link inflation to the money supply, while cost-push and demand-pull theories look at production costs and aggregate demand, respectively, as primary driving factors.
Is Inflation Always Bad?
Moderate inflation can signal a healthy economy, but high inflation can be damaging, much like deflation—a decrease in prices. However, inflation isn’t universally bad; for instance, fixed-rate borrowers may benefit while lenders and savers might suffer.
The Wage-Price Spiral
The wage-price spiral, a subset of cost-push inflation, occurs when rising wages lead to increased demand, resulting in higher prices. These higher prices then compel workers to seek even higher wages, perpetuating the cycle.
Related Terms: demand-pull inflation, aggregate demand, monetarist theory, wage-price spiral, production costs, raw materials.
References
- Organization of the Petroleum Exporting Countries. “Member Countries”.
- U.S. Department of State, Office of the Historian. “Oil Embargo, 1974-1975”.
- Federal Reserve History. “Oil Shock of 1973–74”.
- Board of Governors of the Federal Reserve System. “Why Does the Federal Reserve Aim for Inflation of 2 Percent Over the Longer Run?”
