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What Is Cost-Push Inflation?

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Cost-push inflation

Hurricane Katrina created cost-push inflation.

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Question: What Is Cost-Push Inflation?
Cost-push inflation is one of the three main causes of inflation, the other two being demand-pull inflation and expansion of the money supply. Understand the circumstances that drive cost-push inflation, examples of when it's occurred in the past, and how it affects you.
Answer: Cost-push inflation occurs when there is a shortage of supply of labor, raw materials or capital. The demand remains the same, but since there are fewer goods or services, the supplier can charge more per unit. However, this can only occur if demand for the end product or service is inelastic. That means there is a high demand for the product even if the price goes up.

A good example of inelastic demand is gasoline. People can't easily buy less gas no matter how high the price goes. This is especially true where there aren't good alternatives, such as mass transit. It takes time for people to create alternative modes of transportation, such as joining a carpool or buying a fuel-efficient vehicle. Meanwhile, they just keep buying gas, even if the price rises 40-50% over a few short weeks. Demand will decline, but not at the same rate that prices rose.

If the demand is elastic, then people won't pay the higher prices, they will simply buy less of the product. They'll either switch to a slightly different product or do without. A good example of this is single-family homes. Obviously, people can't do without housing, but if prices go up dramatically over a short period of time, they have other options. They can rent, buy townhomes or condos, or live with friends or relatives.

What Creates Cost-Push Inflation?

Cost-push inflation occurs under five special circumstances. Keep in mind that, whatever the circumstances, rising costs won't create inflation unless producers have the ability to raise prices because demand is inelastic.

First, cost-push inflation can be created by companies that achieve a monopoly over an industry. This has the same effect as reducing the supply, because the company controls the supply of that good or service.

Monopoly power over oil was the goal behind the formation of OPEC, the Organization of Petroleum Exporting Countries. As long as these oil-exporting countries competed with each other on price, they could not receive what they thought was a reasonable value for a non-renewable natural resource. By banding together, the members of OPEC now produce 46% of oil each year, and control 80% of the world's proven oil reserves. As long as they conform to OPEC's price decisions, they can raise oil prices, creating cost-push inflation. This happened during the 1970s oil embargo. OPEC restricted oil in 1973, quadrupling prices.

Wage inflation is a second creator of cost-push inflation. This is when wage earners have the power to force through wage increases, which companies then pass through to consumers in higher prices. This happened in the U.S. auto industry, when the labor unions were able to push for higher wages. Thanks to China and the decline of union power in the U.S., this has not been a driver of inflation for many years.

Natural disasters are a third catalyst for cost-push inflation. This happened right after Japan's earthquake, which disrupted the supply of auto parts. It also occurred after Hurricane Katrina, when oil refineries were destroyed, causing gas prices to skyrocket.

A growing problem will be cost-push inflation as a result of the depletion of natural resources. Each year the price of many types of fish gets higher, thanks to overfishing. The U.S. has recently enacted laws to restrict fisherman to prevent overfishing.

That leads to a fourth driver of cost-push inflation, government regulation and taxation. These regulations can reduce supplies of many other products. Taxes on cigarettes and alcohol were meant to lower demand for these unhealthy products. This may have happened, but more important it raised the price, creating inflation. Government subsidies of ethanol production led to inflation in food prices in 2008. That's because 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.

A fifth, and more complicated, reason for cost-push inflation is a shift in exchange rates. Any country that allows the value of its currency to fall will experience higher import prices. That's because 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 keeps it profit margin intact.(Source: The Intelligent Economist, Cost-Push Inflation; Biz/Ed, Cost-Push Inflation) Article updated March 12, 2012

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