Cost Push Inflation

What is Cost Push Inflation?

Cost-push inflation is the form of inflation caused by substantial increments in the cost of the factors of production like raw materials, labor, factory rent, etc. One cannot alter it as this has no appropriate alternative and ultimately leads to a decrease in the supply of these inputs. It is also known as wage-push inflation.

The hike in production costs like wages or the cost of raw materials results in increased prices for consumers regardless of the demand for the product or service. The effect on real GDP leads organizations to fire a part of their workforce to cope with the hike in price and deterioration in demand, which are a part of the cost push inflation effects.

• Cost push inflation is the inflation that occurs due to substantial increments in the cost of the factors of production such as raw materials, factory rent, labor, etc. 
• One cannot alter it since this has no suitable alternative and ultimately leads to a decrease in the input supply.
• The three major causes of inflation increase are wage push inflation, profit push inflation, and materials.
• The cost of production is the primary driver of cost push inflation increase that decrease aggregate supply in the economy.

Effects

It is important to understand that inflation per se is not such a bad thing. However, the inflation caused by cost-push inflation is somewhat the wrong kind of inflation. Cost-push inflation is characterized by rising prices and falling real GDP. The fall in real GDP despite an increase in the overall price level indicates that the productivity level of the economy is deteriorating. Further, cost-push inflation also affects employment as the decline in real GDP results in decreased demand for goods and services, which compels firms to lay off workers and reduce work. This type of inflation results in a fall in living standards.

Inflation - Video Explanation

How To Control Cost Push Inflation?

The primary driver of cost push inflation increase is the cost of production factor that decreases aggregate supply, i.e., total production of goods, in the economy.

Governments often implement a deflationary fiscal policy such as higher taxes, lower spending, etc., while Central Bank tends to increase the interest rates. Both measures are expected to increase the cost of borrowing, which is likely to cut down consumer spending and investment. However, the problem with higher interest rates is that even though it is expected to reduce the inflation rate, it can result in a big fall in the GDP.

As such, a better long-term cost push inflation solution can be implementing improved supply-side policies that are expected to increase productivity. However, the problem with this solution is that such policies are likely to take a long time to affect the economy.

However, demand for these goods remains steady despite the weakening supply scenario that eventually gives way to the increase in the prices of the goods (inflation).

Causes of Cost Push Inflation

The major three causes for the increase in costs that generate cost-push inflation are the following: -

#1 - Wage push inflation

One of the causes of cost-push inflation is when the increase in labor wages is more than their productivity at work. Since the laborers have to be paid more, the producers increase the price of finished goods to pass on the hike in production cost that eventually results in inflation. This type of inflation is usually seen when there is a strong labor union.

Let us take the example of a company where the workers produce 100 units annually, and their wages are fixed at $20 per hour. Now, let us assume that the labor union has demanded a hike in salaries by 25%. Consequently, the company has increased the wages to $25 per hour. However, the production output has increased from 100 to 110 units annually. There is a difference between the rise in production output (10%) and a rise in wages (25%), known as wage-push inflation.

#2 - Profit push inflation

The causes of cost-push inflation are when entrepreneurs or producers increase the prices of goods and services more than the expectation to garner a higher profit margin that again leads to inflationary conditions.

Let us take an example where the senior management of a company has decided to increase the price of its product from $200 to $230, although there is no corresponding increase in the price of inputs and wages. One can see a 15% rise in profit, leading to inflation. This type of inflation is known as profit-push inflation.

#3 - Material

Another major cause of cost-push inflation is an increase in the prices of key materials (such as steel, energy, oil, etc.) used directly or indirectly in almost the entire economy. Consequently, an increase in the prices of such material significantly influences the cost structure of all industries. Eventually, the economy ends up in the clutches of inflation.

The supply shock created by the Organization of the Petroleum Exporting Countries (OPEC) four decades ago is a classic example of material cost-push inflation. The organization intended to decrease the global oil supply by raising the prices which resulted in a sharp increase in inflation that eventually led to a supply shock.

Besides, some other causes of inflation can be natural disasters and government regulations. A good example of inflation caused by a natural disaster is hurricane Katrina, which created havoc in the U.S. in 2005. The storm destroyed oil refineries which led to soaring gas prices. On the other hand, an example of inflation due to government regulation is a tax on cigarettes and alcohol, leading to the increased cost of these products.

Frequently Asked Questions

Recommended Articles

This article has been a guide to what is Cost Push Inflation. We discuss the causes, effects, and how to control them. We also discuss the measures to control cost-push inflation. You can also go through our other suggested articles: -

• Aggregate Supply
• GDP vs GNP
• Inflation vs Deflation