Cost-Push Inflation

Cost-push inflation is a situation in which the overall price levels go up (inflation) due to increases in the cost of wages and raw materials.

Cost-push inflation develops because the higher costs of production factors decreases in aggregate supply (the amount of total production) in the economy. Since there are fewer goods being produced (supply weakens) and demand for these goods remains consistent, the prices of finished goods increase (inflation).

The most common cause of cost-push inflation starts with an increase in the cost of production, which may be unexpected. This can be related to an increase in the cost of raw materials, unexpected damage or shutdown to a production facility (such as one caused by a fire of natural disaster), or mandatory wage increases for production employees, including instances where a rise in minimum wage automatically increases the compensation of employees who were being paid below the new standard.

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.

One common unexpected cause is a natural disaster. This can include floods, earthquakes, tornadoes or any other large disaster that disrupts any portion of the production chain and leads to increased production costs. Not all natural disasters may qualify, as not all of them result in higher production costs.

Other activities may qualify if they lead to higher production costs. This can include a worker strike, such as one relating to contract negotiations, or a sudden change in government (more often seen in developing nations) that affects the country’s ability to maintain previous output.

While a sudden change in government may be considered unexpected, changes in current laws and regulations may be anticipated even though there may be no reasonable way to compensate for the increased costs associated with them.

The opposite of cost-push inflation, where increased production costs drive the price of a particular good or service up, is demand-pull inflation. Demand-pull inflation includes times when an increase in demand is experienced and production cannot be increased to meet changing needs. In these cases, product costs rise as a reflection of the imbalance in the supply and demand model.

In the early 1970s, the Organization of the Petroleum Exporting Countries (OPEC) wanted a monopoly over oil prices and tried to decrease the global oil supply by raising prices. The group's attempt to raise the price resulted in a supply shock. This is a good example of cost-push inflation, as there was no increase in demand for the commodity.