What is Cost-Push Inflation?
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Causes of Cost-Push Inflation
The major three causes for the increase in costs that generate cost-push inflation are the following: –
#1 – Wage push inflation
One of the causes of cost-push inflation is when the increase in labor wages is more than their productivity at work. Since the laborers have to be paid more, the producers increase the price of finished goods to pass on the hike in production cost that eventually results in inflation. This type of inflation is usually seen when there is a strong labor union.
Let us take the example of a company where the workers produce 100 units annually, and their wages are fixed at $20 per hour. Now, let us assume that the labor union has demanded a hike in salaries by 25%. Consequently, the company has increased the wages to $25 per hour. However, the production output has increased from 100 to 110 units annually. There is a difference between the rise in production output (10%) and a rise in wages (25%), known as wage-push inflation.
#2 – Profit push inflation
The causes of cost-push inflation are when entrepreneurs or producers increase the prices of goods and services more than the expectation to garner a higher profit marginProfit MarginProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. read more that again leads to inflationary conditions.
Let us take an example where the senior management of a company has decided to increase the price of its product from $200 to $230, although there is no corresponding increase in the price of inputs and wages. One can see a 15% rise in profit, leading to inflation. This type of inflation is known as profit-push inflation.
#3 – Material
Another major cause of cost-push inflation is an increase in the prices of key materials (such as steel, energy, oil, etc.) used directly or indirectly in almost the entire economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more. Consequently, an increase in the prices of such material significantly influences the cost structureCost StructureCost Structure refers to those costs or expenses (fixed as well as variable costs) which businesses will incur or will have to incur to produce the desired objective of the business; such costs include the cost of purchasing the raw material to the cost of packaging the finished products.read more of all industries. Eventually, the economy ends up in the clutches of inflation.
The supply shock created by the Organization of the Petroleum Exporting Countries (OPEC) four decades ago is a classic example of material cost-push inflation. The organization intended to decrease the global oil supply by raising the prices which resulted in a sharp increase in inflation that eventually led to a supply shock.
Besides, some other causes of inflation can be natural disasters and government regulations. A good example of inflation caused by a natural disaster is hurricane Katrina, which created havoc in the U.S. in 2005. The storm destroyed oil refineries which led to soaring gas prices. On the other hand, an example of inflation due to government regulation is a tax on cigarettes and alcohol, leading to the increased cost of these products.
Effects
It is important to understand that inflation per se is not such a bad thing. However, the inflation caused by cost-push inflation is somewhat the wrong kind of inflation. Cost-push inflation is characterized by rising prices and falling real GDPReal GDPReal GDP can be described as an inflation-adjusted measure that reflects the value of services and goods produced in a single year by an economy, expressed in the prices of the base year, and is also known as “constant dollar GDP” or “inflation corrected GDP.“read more. The fall in real GDP despite an increase in the overall price level indicates that the productivity level of the economy is deteriorating. Further, cost-push inflation also affects employment as the decline in real GDP results in decreased demand for goods and services, which compels firms to lay off workers and reduce work. This type of inflation results in a fall in living standards.
Measures to Control Cost-Push Inflation
Governments often implement a deflationary fiscal policy Fiscal PolicyFiscal policy refers to government measures utilizing tax revenue and expenditure as a tool to attain economic objectives. read more such as higher taxes, lower spending, etc., while Central Bank tends to increase the interest rates. Both measures are expected to increase the cost of borrowing, which is likely to cut down consumer spending and investment. However, the problem with higher interest rates is that even though it is expected to reduce the inflation rate, it can result in a big fall in the GDPGDPGDP or Gross Domestic Product refers to the monetary measurement of the overall market value of the final output produced within a country over a period.read more.
As such, a better long-term solution to cost-push inflation can be implementing improved supply-side policies that are expected to increase productivity. However, the problem with this solution is that such policies are likely to take a long time to affect the economy.
Conclusion
The primary driver of cost-push inflation increase is the cost of production factor that decreases aggregate supply, i.e., total production of goods, in the economy.
However, demand for these goods remains steady despite the weakening supply scenario that eventually gives way to the increase in the prices of the goodsIncrease In The Prices Of The GoodsThe rate of inflation formula helps understand how much the price of goods and services in an economy has increased in a year. It is calculated by dividing the difference between two Consumer Price Indexes(CPI) by previous CPI and multiplying it by 100.read more (inflation).
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