Cost-push inflation is also called “supply shock inflation”, caused by drops in aggregate supply due to increased prices of inputs, for example. Take for instance a sudden decrease in the supply of oil which would increase oil prices. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices.
Inflation is also caused by increase in the cost of production. As a result of increase in the cost of production, the aggregate supply declines in relation to existing demand of goods and services. Thus, the inflation that occurs due to the pressure of cost is called cost-push inflation. Cost-push inflation can be illustrated with the help of figure:
In above given diagram, aggregate output is shown on the horizontal axis and price level is shown on the vertical axis, ‘AS’ is the aggregate supply curve and ‘AD’ is the aggregate demand curve. Let us suppose that the economy is in equilibrium at the full employment level at the point where output is Q0. The corresponding price level is P0. Now, let us further suppose that there is an upward shift of costs of production from the position of AS0 to AS1. If the money income remains at the same level equilibrium output will fall to Q1 and the price level will rise to P1. Similarly, if the supply function assumes the position AS2, output will diminish to Q2 and prices will be pushed up to P2. This rise in the price level is commonly known as cost push inflation.
The causes of cost push inflation are explained as follows:
(1) Wage- Induced inflation (wage-push Inflation) :
Wage- induced inflation caused by the use of bargaining power of trade unions in raising per unit wage costs. Where trade unions have strong bargaining power, even when the worker’s productivity does not rise, they are able to get wage rates pushed up. Such pushes will lead to autonomous shift in the cost of production even if aggregate demand and level of income remain unchanged. When wages are increased without any corresponding rise in productivity, the resultant upward shift in the aggregate supply function will lead to cost-push inflation.
(2) Profit-induced inflation (profit-push inflation):
Another cause of cost-push inflation is the profit-push. It can occur only under imperfectly competitive markets. Where the monopolists and the oligopolists raise prices of their products more than the increase in cost, this may lead to cost-push inflation.
(3) International Reasons (Supply-Shock inflation):
Every country of the world will have some kind of business or economic relationship with other countries. The countries like Nepal are dependent on foreign countries for construction materials, raw materials, every including consumer goods. Hence, if the prices of these goods increase in foreign countries, the price in Nepal also automatically increase. If the inflation occurs due to price raised by foreign countries such as the price of petroleum by OPEC, it is know as ‘supply-shock’ inflation.