Cost-push inflation occurs when the overall price level rises due to an increase in production costs, such as wages, raw materials, or energy. These higher production costs lead businesses to raise the prices of their goods and services to maintain profitability, which contributes to inflation.
Detailed Explanation:
The price level of an economy can be impacted in the short term by cost-push inflation, which is triggered by a sudden increase in the cost of a commonly used commodity that affects the entire economy. Economists refer to this as a supply shock—an unexpected event that significantly alters the supply of a commodity, leading to a rapid change in its price. Businesses across various industries quickly feel this cost surge. Supply shocks can result from sudden events like natural disasters, wars, terrorism, or political decisions, all of which disrupt supply chains.
As production costs rise, manufacturers are only willing to produce as much if they can raise prices to pass on the higher costs to consumers. The resulting higher prices reduce the economy’s aggregate demand, leading to manufacturers cutting production, often resulting in layoffs and a decrease in real gross domestic product (GDP). When rising prices are combined with a stagnant economy, economists refer to this as stagflation. While such periods typically do not last long, cost-push inflation can be severe enough to cause a recession. Most economists see cost-push inflation as concerning but generally unsustainable, as the economic slowdown eventually eases the upward pressure on prices.
Cost-push inflation affects the entire economy, but it can be easier to understand on a micro level. Imagine you own a lawn care business, and suddenly, the price of gasoline jumps by 50%. Gasoline is a critical input for your services, as you need it to drive to customers’ homes and power your equipment. With the sharp increase in fuel costs, servicing customers who live 30 miles away becomes unprofitable. As a result, your supply curve shifts to the left. You raise your prices to maintain your profit margin, even though you expect to lose some customers.Graph 1 illustrates your quandary. In the graph, your supply curve shifts from Supply1 to Supply2. Consequently, your equilibrium price rises from P1 to P2, and you are now only willing to serve Q2 customers at the higher price.
Graph 1
Other businesses face similar challenges and raise their prices as well, causing their supply curves to shift to the left. The increased operating costs push up production expenses for most businesses, leading them to pass these cost increases on to consumers in the form of higher prices. As a result, consumers are less willing to purchase goods and services at these higher prices, leading to a decline in overall production.
Graph 2 illustrates the impact of stagflation on the entire economy using the aggregate supply and demand model. Short-run macroeconomic equilibrium occurs where the short-run aggregate supply (SRAS) and aggregate demand (AD) curves intersect. Initially, the aggregate supply is represented by SRAS1, with the economy’s equilibrium price level at PL1 and real gross domestic product (RGDP) at RGDP1. After a supply shock raises production costs, the short-run aggregate supply curve shifts to SRAS2, causing the price level to rise to PL2 while output falls to RGDP2.
Graph 2 In the early 1970s, the Arab oil-producing countries imposed an embargo on the United States and its allies due to their support for Israel in the Yom Kippur War. The embargo led to a sudden halt in oil trade between the Arab oil-producing countries and the American allies. The resulting decrease in oil supply caused oil prices to surge, leading to higher energy costs that had a swift and widespread impact on the economy. The increase in energy costs affected virtually every product, as energy is required for production and transportation.
Supply shocks are typically associated with negative events like the Arab Oil Embargo. However, the opposite effect occurs when the cost of manufacturing most products significantly decreases. If a new technology benefits most industries, it can quickly cause a positive supply shock. For instance, the widespread use of the internet improved efficiency in many businesses, leading to lower production costs. A positive supply shock reduces an economy’s price level while increasing its level of production.
