When Rising Costs Get Passed to the Customer

What this means

Everything a firm sells was made out of purchased inputs: labor, raw materials, energy, transport, rent, borrowed money. When the price of those inputs rises, the cost of producing each unit rises. At the old selling price, the firm's margin shrinks, and it faces a decision rather than an automatic outcome.

If enough firms across the economy raise their selling prices in response, the average price level rises. That is cost-push inflationInflation driven by increases in the cost of producing goods and services, passed on to buyers through higher prices., and it is a specific case of the supply side of inflation: higher costs make firms willing to supply less at any given price, so the economy's overall supply contracts.

Notice the conditional built into the benchmark, because it is the whole intellectual content of this lesson. Costs cause inflation if firms are able to pass along higher costs to consumers. The ability is not guaranteed. Pass-throughThe share of a cost increase that a firm succeeds in transferring to buyers through a higher price. depends on the situation.

Two things govern it. The first is how sensitive buyers are to price. If the product has close substitutes, or is easy to postpone, or takes a large share of a household's budget, buyers respond to a price increase by buying much less, and the firm that raises prices loses more in volume than it gains in margin. Necessities with few substitutes are the opposite case, and pass-through there is high. The second is what competitors do. A firm alone in facing a cost increase is in a weak position; a firm whose rivals all face the identical increase is in a much stronger one, because none of them can undercut without absorbing the cost themselves. This is why an economy-wide input shock passes through more completely than a cost increase specific to one company.

When pass-through fails, the cost increase does not vanish. It gets absorbed as a smaller profit margin, or it is met by cutting other costs, reducing quantity, shrinking the product, or in the harder cases by the firm reducing output or shutting down. Each of those is also a contraction in supply, which is why a cost shock tends to push prices up and output down together whichever route it takes.

Energy is the input that matters most for this benchmark, because it is unusually pervasive. Energy is not one item in the basket. It is an input to manufacturing, to agriculture, to heating and cooling every commercial building, and above all to moving goods, which means a fuel price increase reaches the price of items that use no fuel themselves. A good produced without energy still has to be shipped. That is what makes energy shocks show up across an index rather than in one category of it.

One more mechanism completes the picture. If workers expect prices to keep rising, they seek wage increases to protect their purchasing power, and higher wages raise production costs again. Whether this becomes a self-sustaining wage-price spiralA pattern in which rising prices lead to higher wage demands, which raise costs and prices further, feeding back into wage demands. depends heavily on inflation expectationsWhat households and firms believe the inflation rate will be in the future, which shapes the wage and price decisions they make now., which is why central banks pay close attention to whether people expect inflation to persist.

Why it matters

This is the part of inflation you can watch happen. Menu prices, delivery fees, and shipping surcharges are all visible pass-through decisions, and once you know what to look for, you can read a business's pricing as evidence about the conditions it faces.

It also improves the quality of the arguments you will hear. "Corporate greed causes inflation" and "wage increases cause inflation" are both stated as though they settled something. Neither identifies the actual question, which is why a price increase succeeded. Firms would prefer higher prices at all times; what changes is whether buyers and competitors permit it. Placing the conditional at the center of the analysis is what separates an explanation from an accusation.

Try it

1. Set up a single firm before analyzing an economy. A bakery sells bread at 4 dollars a loaf and its costs per loaf are 3 dollars, split among flour, labor, energy, and rent. Compute the margin per loaf.
2. Energy costs rise enough to add 40 cents to the cost of each loaf. Compute the new margin if the price does not change. Then compute the price that would fully restore the original margin.
3. List every option the bakery has other than raising the price to that level. Aim for at least four, and include ones that change the product rather than the price.
4. Add competition. Case A: the bakery is the only one in town. Case B: three other bakeries are nearby and all face the same energy increase. Case C: three other bakeries are nearby but they use a different energy source and their costs did not change. Predict the pass-through in each case and explain your reasoning in one sentence per case.
5. State the general rule you just derived, in your own words, about when a firm can pass a cost increase to customers.
6. Scale it up. Explain what happens to the inflation rate when businesses across the whole economy face an increase in energy costs. Your answer must trace at least two paths by which the increase reaches products that do not themselves consume much energy.
7. Predict what happens to output and employment in that economy-wide case, and say whether this looks more like demand-driven or supply-driven inflation.
8. Get real data. On FRED, chart the CPI for energy alongside the overall CPI for the last twenty years. Identify one period of a sharp energy move and describe what the overall index does during and after it.
9. Add the expectations loop. Explain how workers responding to higher prices with wage demands could extend an initial energy shock into a longer episode of inflation, and state one condition that would stop the loop rather than sustain it.
10. Field observation. Over one week, find three real examples of a business responding to costs: a posted surcharge, a visibly smaller portion or package, a removed menu item, or an announced price change. For each, name which response from your step 3 list it is and what it suggests about that business's pass-through ability.

Check yourself