Rising production costs can raise prices while weakening output.
Cost-push inflation can arise when higher economy-wide input costs or adverse production conditions reduce aggregate supply. Imported energy or materials, supply disruptions, and wage growth beyond productivity growth can increase unit costs. A firm paying higher wages is not automatically facing higher unit labour cost if productivity rises sufficiently. With AD unchanged, an adverse AS shift raises the price level and reduces real output in the usual model. Repeated shocks or continuing wage-price feedback can prolong inflation; a single cost increase does not explain indefinite inflation without an additional mechanism.
- Cost pressure
- Cost-push inflation can arise when higher input costs or disrupted production reduce aggregate supply (AS). More expensive imported energy or wages rising faster than productivity can raise production costs per unit.
- Unit labour cost
- Unit labour cost means labour cost per unit of output. Divide pay per worker-hour by output per worker-hour. Higher pay need not increase the cost per unit if workers also produce more each hour.
- AD/AS effect
- With aggregate demand (AD) unchanged, an adverse supply change shifts AS up/left: firms need higher prices to supply a given output. The usual result is a higher price level and lower real output.
From higher costs to higher prices
Pass-through
Pass-through means passing higher costs on to buyers through higher prices. Firms may instead accept less profit per unit, narrowing their margin. Demand, competition and existing price contracts affect how much they can pass on.
Continuing inflation
Further cost shocks can extend inflation. Wage-price feedback is another possible route: rising living costs lead workers to seek higher pay; if pay outpaces productivity and firms raise prices again, the pressure continues. This is conditional, not an automatic result of every pay rise.
| Case | Pay per hour | Output per hour | Labour cost per unit |
|---|---|---|---|
| Initial | $20 | 10 | $2 |
| A: productivity also rises | $22 | 11 | $2 |
| B: productivity unchanged | $22 | 10 | $2.20 |
Worked example: A pay rise with and without higher productivity
Average pay per hour rises from $20 to $22. In case A, output per worker-hour rises from 10 to 11 units. In case B, output per worker-hour stays at 10. Other costs are unchanged.
- Initially labour cost per unit is $20/10 = $2.
- In A, $22/11 is still $2 per unit: productivity offsets the wage rise.
- In B, $22/10 = $2.20, a 10% unit labour-cost increase. If widespread and not offset elsewhere, this can create adverse AS pressure.
- Whether firms pass on all the increase depends on demand, competition, contracts and margins; the wage figure alone does not establish the final inflation rate.
Watch out for this
Any wage increase necessarily produces cost-push inflation.
Compare wages with productivity and other costs, and explain economy-wide pass-through rather than assuming it.
Check your understanding
Pay per hour and output per hour both rise 10%. What happens to unit labour cost, other things equal?
- It is unchanged.
- It necessarily rises 20%.
- It becomes zero.