Cost-push inflation occurs when supply costs rise or supply levels fall. Either will drive up prices—as long as demand remains the same.
Shortages or cost increases in labor, raw materials, and capital goods create cost-push inflation. These components of supply are also part of the four factors of production.
- Cost-push inflation occurs when the supply of a good or service changes, but the demand for it stays the same.
- It occurs most often when a monopoly exists, wages increase, natural disasters occur, regulations are introduced, or exchange rates change.
- Cost-push inflation is rare.
Five Causes of Cost-Push Inflation With Examples
Cost-push inflation is rare. It only occurs under five special circumstances. In all of these circumstances, demand is inelastic.
Companies that achieve a monopoly in an industry can create cost-push inflation. A monopoly reduces supply to meet its profit goal.
One good example is the Organization of Petroleum Exporting Countries (OPEC), which sought monopoly power over oil prices. Before OPEC, its members competed with each other on price. They didn't receive a reasonable value for a non-renewable natural resource. OPEC members now produce 37% of oil each year. The member nations also controlled nearly 80% of the world's proven oil reserves.
OPEC members created cost-push inflation during the 1970s oil embargo.
When OPEC restricted oil in 1973, it quadrupled prices. In 2014, shale oil producers challenged OPEC's monopoly power. Prices dropped as a result. They created a U.S. shale oil boom and bust.
2. Wage Inflation
Wage inflation occurs when workers have enough leverage to force through wage increases. Companies then pass higher costs through to consumers. The U.S. auto industry experienced it when labor unions were able to push for higher wages.
As a result of the decline of union power in the U.S., it hasn't been a driver of inflation for many years. This is sometimes called "wage push inflation."
3. Natural Disasters
Natural disasters cause inflation by disrupting supply. One good example is right after Japan's earthquake in 2011, which disrupted the supply of auto parts. It also occurred after Hurricane Katrina. When the storm destroyed oil refineries, gas prices soared.
The depletion of natural resources is a type of natural disaster. It has the same effect, by limiting supply and causing inflation. For example, fish prices are rising due to overfishing. Recent U.S. laws try to prevent it by limiting fishermens' catches.
4. Government Regulation and Taxation
A fourth driver is government regulation and taxation. These rules can reduce supplies of many other products. Taxes on cigarettes and alcohol were meant to lower demand for these unhealthy products. That may have happened—but more importantly, it raised prices and created inflation.
Government subsidies of ethanol production led to soaring food prices in 2008. Agribusinesses grew corn for energy production, taking it out of the food supply. Food prices were so high that there were food riots around the world that year.
5. Exchange Rates
The fifth reason is a shift in exchange rates. Any country that allows the value of its currency to fall will experience higher import prices. The foreign supplier does not want the value of its product to drop along with that of the currency. If demand is inelastic, it can raise the price and keep its profit margin intact.
What Is Inelastic Demand?
Inelastic demand is when people still buy the good or service even if the price goes up. For example, inelastic demand occurs with gasoline.
Most people can't simply stop buying gas just because the price increases—no matter how high it goes. It's even worse for those who don't have good alternatives, such as mass transit. It takes time for people to find alternatives, such as joining a carpool or buying a fuel-efficient vehicle. Until then, they need the same amount of gas.
When demand is elastic, people won't pay the higher prices. They'll simply buy less of the good or service. They'll either switch to a slightly different product or do without it.
Single-family homes are a good example. If prices rise, they have other options. They can rent, buy townhomes or condos, or maybe even live with friends or relatives. Higher housing prices and higher gas prices are just some of the ways that inflation impacts your life. Fortunately, the Federal Reserve can do a lot to control inflation.
Cost-push inflation can only occur when demand is relatively inelastic.
Cost-Push vs. Demand-Pull Inflation
Cost-push is one of the two causes of inflation. The other is demand-pull inflation. Demand-pull inflation is the primary cause of inflation. It occurs when the aggregate demand for a good or service outstrips aggregate supply, and it starts with an increase in consumer demand. Sellers try to meet the higher demand with more supply. If they can't, then they raise their prices.
Expansion of the money supply is another cause of inflation. That occurs when the government prints too much money, which has happened in the past to cause hyperinflation. It is one of the four types of inflation. The other three types of inflation are "creeping," "walking," and "galloping."
Expansion of the money supply also occurs when a nation's central bank expands bank credit. It usually does this by lowering interest rates.
Frequently Asked Questions (FAQs)
How is inflation measured?
Most analysts use the Consumer Price Index (CPI) to measure inflation. The CPI cumulatively measures average price changes in a basket of consumer goods. Since the measurement averages out price changes across many different categories, it doesn't perfectly reflect the inflation felt by any particular person.
How does inflation affect stocks?
If prices rise generally throughout an economy, you could also expect stock prices to rise. As long as inflation stems from a healthy, growing economy, stocks typically perform well. However, when inflation gets too hot, the government might shift toward a contractionary fiscal policy. These measures, such as hiking interest rates and increasing the cost of borrowing, could slow economic activity and depress stock prices.