We've discussed inflation in a recent blog. It means a reduction in the everyday consumer's purchasing power. This reduction in purchasing power comes from an increase in the prices of goods and services offered in an economy.
When "an increase in prices of goods and services" is mentioned, it doesn't mean the rise in the price of singular goods or individual services. Inflation is usually observed when the prices of a "basket" or group of goods and services increase.
Inflation has different varieties, though. The two most common ones are demand-pull inflation and cost-push inflation. Today we learn about the latter of the two.
Cost-push inflation is a phenomenon where the prices of goods and services rise due to the supply of these commodities being unable to keep up with the demand for the same. While in the case of demand-pull inflation, the demand increases far beyond the supply, in the case of cost-push inflation, the demand remains the same while the supply begins to lag.
This fall in supply is caused by the rise in the cost of production. This makes the acquisition of raw materials and execution of the production process a costlier endeavour. The producers can procure fewer quantities of raw materials if they maintain the same level of expenditure on production.
Consumer demand is usually inelastic in an economy where cost-push inflation is observed. Inelastic demand means that the demand for the commodities experiencing the price rise remains unaffected by the price. Demand like this is seen in the case of necessities, like medicines, where the price may significantly rise, but the demand for the commodity stays unchanged.
Another commodity that experiences inelastic demand is the one without any close substitutes. This means that there are no viable replacements for the commodity, and as a result, consumers are stuck buying the same product irrespective of its price.
Kinds of Cost-Push Inflation
Cost-push inflation usually occurs due to one of these three primary reasons. As these factors affect the significant inputs of the production process, they are also considered the chief types of cost-push inflation.
When these workers achieve a monopolistic position (as labour unions or similar organisations), they demand higher wages for the same amount of exerted effort.
From the company's perspective, the cost of production increases but the quantity itself does not. To keep profit margins healthy, companies increase the price of their product to cover this increased cost.
This price increase thus results in inflation from the supply side of production.
Profit-push Inflation: Similar to wage-push inflation, this type occurs when a different factor of production exercises its monopolistic power. Factors of production include land, labour, capital and entrepreneur/enterprise.
What wage-push is for labour, profit-push is for… Can you guess it? Well, if you guessed entrepreneur, you are correct. Profit is the income that corresponds to the owner of the business.
Thus, the "profit-push" variant of cost-push inflation takes place when the producers of goods/services choose to increase the prices of their offering to increase profits.
But why increase the prices? Is there no other way to improve an organisation's profits?
Well, there is another way. If a company is already making profits with its products at the existing price levels, one way to increase said profits is to increase its production. This, coupled with increased sales, would increase the profits by the percentage of production increment.
However, this method isn't too easy to follow, as most companies usually operate at the maximum productivity levels of the assets they employ. Thus increasing production would involve acquiring more assets and resources, which are not feasible for most companies in the long run.
As a result of this short-term limitation, companies choose the aforementioned price-hike and cause inflation.
Since the supply of the raw material is compromised from the source, usually, there isn’t much the parties involved in the production process can do to remedy this. Thus the production process takes a hit, and supply is reduced. This reduced supply has an impact on the price of the product.
When the supply of the finished goods is reduced, the various users of the product (end-users, resalers, parties purchasing for further value addition) still need their supply requirements met. A lack of raw materials means all the suppliers are equally unable to fulfil this demand. As a result, the buyers of the goods start “bidding up” the product's price to meet their needs at the reduced supply levels.
Notice that in this case, the price is increased by the buyers and not the sellers. The inflation is still said to have originated from the supply side. This is the case because the price rise occurs due to supply being unable to keep up with the same level of demand and not the demand growing beyond the supply’s potential.
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Other Reasons for Cost-Push Inflation
The reasons mentioned above are the more significant causes of cost-push inflation. Following are some of the underlying reasons that trigger cost-push inflation.
Costlier Aids-to-Trade: The scope of the concept of commerce is divided into two categories. They include trade and aids-to-trade. Aids-to-trade are various services available to companies to help them execute their business. These include; transport, warehousing, insurance, banking and finance, advertising, communication and many more services that fulfil the above-mentioned criterion of helping in the execution of businesses.
These services are obviously not free. If the cost incurred in availing of these services goes up, the cost of production inadvertently does too. The increased cost burden is shifted to the consumer through increased prices.
Natural Disasters: Natural disasters disrupt the production process by hindering the producer’s access to raw materials. Natural disasters can also cause damage to production facilities which may reduce the supply and make them unable to keep up with prevalent demand levels.
Change in Government or its Policies: If the existing government is overthrown by its opposition or the current government changes the policies under which the business operates, the business can face adversities.
Changes that can affect the business include changes in pricing policies, tax laws, legal processes involved in the set-up or running of a business, etc.
If the new government or policy structure negatively affects the business, its performance could be similarly affected, and the supply of products from the company might take a hit.
Devaluation of National Currency: If the value of a nation’s currency falls in relation to other foreign currencies, more of the national currency will be needed when the country engages in imports. Imports cannot be stopped entirely as the distribution of raw materials and other resources aren’t equal across various countries.
This devaluation of the national currency will cause the price of said imported products to increase. The price rise will be direct if the imports are used as finished goods. However, if the imports act as raw materials, the increased cost burden will be shifted to the consumer, ultimately increasing the product's price.
While researching for this article, I came across a rather strange phenomenon related to the cost-push inflation situation. This strange phenomenon is called the “Wage-Price Spiral”. Those of you familiar with the term, bear with me. Those about to find out about it as I did, here goes.
A wage-price spiral is a vicious cycle of inflation. The spiral, once triggered, keeps fueling itself and can hypothetically increase inflation exponentially if not controlled promptly. This self-feeding cycle is set off with an increase in wages. As these wages rise, the price of finished goods goes up due to wage-push inflation.
Now, to survive with these prices, workers demand a greater raise in their wages. If this demand is met, the prices go up again, and the cycle keeps feeding itself, growing inflation exponentially until stopped.
End of Inflation
Out of demand-pull or cost-push inflation, the latter is an extremely rare phenomenon. This is so because of the specificity of what goes into triggering cost-push inflation. The cause of cost-push inflation is also mostly psychological or chance-based, making its occurrence difficult.
Demand-pull inflation is caused by the natural growth of income and purchasing power in the economy. In contrast, cost-push inflation occurs due to micro-economic entities causing irregularities in the macro-economic scale (people’s greed causes market instability).
Well, I’m going to call this article done and dusted. After all, too much education at once can get a bit bogged down. So, see you on the next blog!