Cost-Push Inflation: When It Occurs, Definition, and Causes

What Is Cost-Push Inflation?

Cost-push inflation happens when businesses raise the price of goods and services because the cost of producing them increases. Let's say you run a lemonade stand. The cost of the lemons, sugar, and water you need to make your lemonade goes up from last month. To continue making a profit, you need to pass that increase off to your customers. That's known as cost-push inflation. Cost-push inflation can also be influenced by higher wages, taxes, and supply-chain issues, or when higher costs decrease the aggregate supply in the economy.

Understanding Cost-Push Inflation

Inflation is a measure of the rate of price increases in an economy for a basket of selected goods and services. Inflation can erode a consumer’s purchasing power if wages haven’t increased enough or kept up with rising prices. If a company’s production costs rise, the company’s executive management might try to pass the additional costs on to consumers by raising the prices for their products. If the company doesn’t raise prices, while production costs increase, the company’s profits will decrease.

The most common cause of cost-push inflation starts with an increase in the cost of production, which may be expected or unexpected. For example, the cost of raw materials or inventory used in production might increase, leading to higher costs.

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.

Causes of Cost-Push Inflation

As stated earlier, an increase in the cost of input goods used in manufacturing, such as raw materials, is a cause of cost-push inflation. For example, if companies use copper in the manufacturing process and the price of the metal suddenly rises, companies might pass those increased costs on to their customers.

Increased labor costs can create cost-push inflation, such as when mandatory wage increases for production employees due to an increase in the minimum wage per worker. A worker strike due to stalled contract negotiations might also lead to a decline in production and, as a result, lead to higher prices.

Unexpected causes of cost-push inflation are often natural disasters, which can include floods, earthquakes, fires, or tornadoes. If a large disaster causes unexpected damage to a production facility and results in a shutdown or partial disruption of the production chain, higher production costs are likely to follow. A company might have no choice but to increase prices to help recoup some of the losses from a disaster. However, not all natural disasters result in higher production costs and, therefore, wouldn’t lead to cost-push inflation.

Other events might qualify if they lead to higher production costs, such as a sudden change in government that affects the country’s ability to maintain its previous output. However, government-induced increases in production costs are more often seen in developing nations.

Government regulations and changes in current laws, although usually anticipated, may cause costs to rise for businesses because they have no way to compensate for the increased costs associated with them. For example, the government might mandate that healthcare be provided, driving up the cost of employees or labor.

Cost-Push vs. Demand-Pull

Rising prices caused by consumers wanting more goods is called demand-pull inflation. Demand-pull inflation includes times when an increase in demand is so great that production can’t keep up, which typically results in higher prices. In short, cost-push inflation is driven by supply costs while demand-pull inflation is driven by consumer demand—while both lead to higher prices passed on to consumers.

Example of Cost-Push Inflation

The Organization of the Petroleum Exporting Countries (OPEC) is a cartel that consists of 12 member countries that both produce and export oil. In the early 1970s, due to geopolitical events, OPEC imposed an oil embargo on the United States and other countries. OPEC banned oil exports to targeted countries and also imposed oil production cuts.

What followed was a supply shock and a quadrupling of the price of oil from approximately $3 to $12 per barrel. Cost-push inflation ensued since there was no increase in demand for the commodity. The impact of the supply cut led to a surge in gas prices as well as higher production costs for companies that used petroleum products.

The Bottom Line

Cost-push inflation occurs when overall prices increase due to increases in the cost of wages and raw materials. It can also occur when higher costs of production decrease the aggregate supply in the economy. When production falls while demand for goods remains changed, price increases from production are passed on to consumers, creating cost-push inflation.