Cost-push inflation is inflation triggered by a sudden cost increase of a commonly used commodity and a reduction in an economy’s aggregate supply.
The price level of an economy can be affected in the short-term by cost-push inflation, which is inflation triggered by a sudden cost increase of a commonly used commodity that reverberates throughout the economy. Economists call this a supply shock. A supply shock is an unexpected event that results in a dramatic change in the supply of a commodity, which in turn swiftly results in a change in the commodity’s price. The sudden cost change is quickly felt by most companies. Supply shocks may be brought on by sudden events such as natural disasters, wars, terrorism, or political decisions. All disrupt the supply chain. Manufacturers are not willing to produce as much at the higher cost unless they can charge a higher price and pass most of the cost through to their customers. The higher price lowers the quantity demanded by consumers, which leads to manufacturers cutting production. In many cases workers are laid off. Real gross domestic product drops. Economists call these periods stagflation because the rising prices are combined with a stagnant economy. Fortunately, these periods normally do not last for very long. Most economists view cost-push inflation as troubling but not sustainable because a slowing economy will eventually lead to reduced pressure on price levels. However, cost-push inflation can be severe enough to eventually cause a recession.
Cost-push inflation impacts the entire economy, but it is helpful to view it on a micro level. Imagine you own a lawn care business. Suddenly the price of gasoline jumps 50 percent! Gasoline is an essential input for the services you provide. Your cost to drive to your customers’ homes and power your equipment increases so much that you will actually lose money if you continue to service customers who live 30 miles away. Your supply curve has shifted to the left. You choose to charge your customers a higher price even though you know you will lose a few of them. Graph 1 illustrates your quandary. On graph 1 your supply curve shifts from Supply1 to Supply2. Your equilibrium price increases from P1 to P2, and you are only willing to service Q2 customers.
Other businesses share your pain and raise their prices. Their supply curves also shift to the left. The added operating cost pushes up the cost of production for most businesses, so they pass the cost increase through to consumers as higher prices. Consumers are not willing to purchase as many goods and services at the higher prices, so production decreases.
Graph 2 illustrates the hardship stagflation inflicts on the entire economy using the aggregate supply and demand model. Short-run macroeconomic equilibrium is achieved where the short-run aggregate supply (SRAS) and aggregate demand (AD) intersect. SRAS1 is the initial aggregate supply. Initially, the economy's equilibrium price level and real gross domestic product (RGDP) are PL1 and RGDP1. The short-term aggregate supply curve shifts to SRAS2 after a supply shock pushes manufacturer’s costs higher. Inflation follows. The price level jumps to PL2. Output drops to RGDP2.
In the early 1970s, the Arab oil-producing countries embargoed the United States and its allies for supporting Israel in the Yom Kippur War. Trade in oil between the Arab oil-producing countries and the American allies suddenly ceased. The dramatic decrease in supply propelled oil prices higher. Higher energy costs were quickly felt throughout the economy. Every product requires energy to produce and energy to deliver to the market place, so virtually every product was impacted by the sudden increase in energy costs.
Supply shocks are normally associated with something bad happening—like the Arab Oil Embargo. However, the reverse impact happens following a significant decrease in the cost to manufacture most products. Technological advances could quickly trigger a positive supply shock if the advance is useful in most industries. For example, the widespread use of the Internet increased efficiency in most businesses, resulting in a lower cost of production. A positive supply shock decreases an economy’s price level, while increasing its level of production.