What is Cost-Push Inflation?

Oil is pervasive enough that a rise in price could cause cost-push inflation

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Cost-push inflation is a theory of inflation that results when the aggregate (total) costs of production rise without a corresponding increase in productivity. It could be an increase in the cost of raw materials, transportation, labor, or anything else that increases the costs of a company or industry. That increased cost pushes the prices of the finished goods higher and thus decreases the purchasing power of money, causing inflation. It is an element of Keynesian economics in contrast to monetarism.

Not all price increases result in inflation, even if the increase is caused by higher production costs. For inflation to occur the production cost increase must affect a significant amount of production and there can’t be a suitable alternative for the consumer. If one soft drink manufacturer makes a series of bad decisions and starts running their business inefficiently, that won’t cause cost-push inflation. Consumers will respond to their higher prices by buying less soda from them while buying more of some other brand. Even if there were no other soft drinks available in a particular place, the increased expense would be negligible when spread out over everything else that the consumers buy in that area.

Additionally, if productivity increased along with costs, cost-push inflation wouldn't occur because there would be more goods available for an industry to sell and profit from. Those increased profits would negate the effect of their increased costs so prices wouldn't rise.

Cost-Push Inflation Example

If the cost of oil rises, that can cause cost-push inflation. Oil is used in the making of numerous products; it is also part of the distribution/transportation cost of numerous other products. There won’t be oil-free alternatives for that many products. Consumers will have no choice but to absorb the higher prices and continue purchasing those products. The newer, higher prices will cause cost-push inflation because the price of a wide range of products will be affected. The purchasing power of everyone’s money will be a bit lower.

If inflation is high it is likely that unemployment is low. Cost-push inflation can in turn result in a wage/price spiral.

Wage/Price Spiral

In a period of high inflation the money supply is high. Unemployment will probably be low resulting in companies having to offer high wages to attract qualified workers. Unions will also bargain to increase wages. Those high wages will increase the companies’ production costs again. This can result in a spiral where the prices of goods rise to protect companies against inflation, and correspondingly, wages rise to protect consumers from inflation. Every cycle of additional costs is followed by a cycle of increased wages resulting in further inflationary pressure.

Adaptive Expectations

Adaptive expectations is a theory related to the wage/price spiral. This theory says that people will estimate the future of a trend (like inflation) by using the past rates as a guide. Under this model, companies would be expected to continue raising prices at the same rate as wages and other costs have increased, and workers and unions would be expected to seek wage increases that are at least commensurate with inflation.

A natural disaster could disrupt distribution channels enough to cause a supply shock

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Supply Shock

A related situation that can cause cost-push inflation, usually in the short term, is a negative supply shock. This is when the supply of an important commodity is sharply reduced. An example would be a drought or other natural disaster that destroys a widely used food product like wheat. Another example is war or terrorism affecting the supply of oil since much of it comes from volatile countries.

Argument Against Cost-Push Inflation: Monetarist Theory

Monetarists (beginning with Milton Friedman) argue that cost-push inflation doesn’t really exist. Since inflation is ultimately caused by an increase in the money supply, they say that an increase in production costs alone cannot cause inflation.

If production costs increase and prices then increase but the government doesn’t increase the money supply, consumers will have less money available for purchasing other goods and services. That will reduce the demand for some other products which will lower those prices, thus offsetting the inflationary effect of the other higher production costs and prices. The reduced demand for some of the other products with the correspondingly lower profits from them would increase unemployment. Some workers would move over to the other industry or businesses that are thriving but not everyone would be qualified. The result would ultimately be negative (increased unemployment) but not inflationary.

The theory of adaptive expectations is also disputed. The theory of rational expectations, developed by John Muth, argues that individuals will take all available information into account when trying to make a guess about future inflation rates. Past increases will be considered but not exclusively. They say that all pertinent data and economic expectations will be considered when trying to determine inflation rates.

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