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What Is Cost-Push Inflation?
Cost-push inflation is inflation that results from higher production costs and rising prices of raw materials. Cost-push inflation occurs when the aggregate supply of goods and services decreases because of an increase in production costs. For instance, if low-paid workers in a factory form a union and demand higher wages, it’s possible the factory owner will simply shut down the business in response. This leads to decreased manufacturing and higher prices in the market.
What Causes Cost-Push Inflation?
There are four principal factors of production: labor, capital, land, or entrepreneurship. When any one of these rises, it can be the cause of price increases throughout an industry.
- Labor expenses typically have to do with salaries and benefits. Unions may negotiate for wage increases. Government regulation may mandate that an employer provide healthcare and paid vacation, which count as expenses.
- Capital relates to a business’s ability to borrow money. Borrowed money allows a business to expand its market footprint, invest in new technologies, or build new facilities. Increased interest rates or an unfavorable exchange rate from a foreign investor can limit a business’ money supply, and thus they too can affect the overall price level of that business’s products.
- Land expenses include rent, construction costs, and perhaps even the need to respond to natural disasters (such as if a factory is located in a flood plain). This helps explain why environmental events can spike an economy’s inflation rate.
- Entrepreneurship expenses occur in the process of turning an idea into a functioning business. Major investments must be made in raw goods, employees, and workspace. These factors can quickly create a general price increase in a company’s products, and thus they are also potential causes of inflation.
Case Study: OPEC as an Example of Cost-Push Inflation
A famous example of cost-push inflation occurred in the 1970s oil market. The price of oil is controlled by an intergovernmental body known as OPEC—the Organization of Petroleum Exporting Countries. In the Seventies, OPEC imposed higher prices on the oil market; however, demand had not increased. While the increased oil prices produced strong profit margins for producers in the short run, it increased production costs in all sectors of the economy that relied on oil. This impacted many elements of the economy are touched by the oil market, from transportation to construction to plastics, resulting in inflationary pressure on the prices of goods and services as a result of OPEC’s decision.
What Is the Difference Between Cost-Push Inflation and Demand-Pull Inflation?
Cost-push inflation is propelled by supply-side factors: an increased price of goods and raw materials leads to a greater cost of production. By contrast, demand-pull inflation is consumer driven. It is the type of inflation that results when an economy’s aggregate demand exceeds its aggregate supply. To put this in simple terms, when production cannot keep up with consumer demand, higher prices quickly follow.
What Is the Wage-Price Spiral?
The relationship between rising labor costs and inflation can be described by the wage-price spiral. The wage-price spiral combines the concepts of cost-push inflation and demand-pull inflation. Increased wages lead to cost-push inflation, while increased demand leads to demand-pull inflation. The two feed off each other and create this veritable “spiral”:
- Rising wages increase disposable income for workers.
- More disposable income leads to greater demand for discretionary goods and services.
- The increased demand for goods and services causes prices to rise.
- Rising prices prompt workers to demand higher wages.
- The higher wages lead to higher production costs and the cycle repeats.
Learn more about economics and society with Paul Krugman.