Menu Cost

In economics, the menu cost is a cost that a firm incurs due to changing its prices. It is one microeconomic explanation of the price-stickiness of the macroeconomy put by New Keynesian economists. The term originated from the cost when restaurants print new menus to change the prices of items. However economists have extended its meaning to include the costs of changing prices more generally. Menu costs can be broadly classed into costs associated with informing the consumer, planning for and deciding on a price change and the impact of consumers potential reluctance to buy at the new price. Examples of menu costs include updating computer systems, re-tagging items, changing signage, printing new menus, mistake costs and hiring consultants to develop new pricing strategies. At the same time, companies can reduce menu costs by developing intelligent pricing strategies, thereby reducing the need for changes.

Menu costs and nominal rigidity

Menu costs are the costs incurred by the business when it changes the prices it offers customers. A typical example is a restaurant that has to reprint the new menu when it needs to change the prices of its in-store goods. So, menu costs are one factor that can contribute to nominal rigidity. Firms are faced with the decision to alter prices frequently as a result of changes in the general price level, product costs, market structure, regulation and demand level. Despite frequent market changes, businesses may be hesitant to update prices to reflect these changes due to menu costs. If the menu cost outweighs the expected increase in revenue associated with the price change firms would prefer to exist in disequilibrium and stay at the original price level. When the nominal price level remains constant despite market change is said that there is nominal rigidity or price stickiness in the market. For example, a restaurant should not change its prices until the price change generates enough additional revenue to cover the cost of printing a new menu. Thus, menu costs can create considerable nominal rigidity in other industries or markets, essentially amplifying their impact on the entire industry through a chain reaction of suppliers and distributors.

History

The concept of the menu cost has originally introduced by Eytan Sheshinski and Yoram Weiss (1977) in their paper looking at the effect of inflation on the frequency of price changes. Sheshink and Weiss concluded that even fully anticipated inflation results in an actual menu cost for the business. They suggested that businesses will change prices in discrete jumps rather than continual changes when in an inflationary environment. This justifies the fixed costs of changing prices when revenues are expected to increase.

The idea of applying menu costs as an aspect of Nominal Price Rigidity was simultaneously put forward by several New Keynesian economists in 1985–6.In 1985, Gregory Mankiw concluded that even small menu costs create inefficient price adjustment and push equilibrium below the point which is socially optimal. He further suggested that the subsequent loss of welfare far exceeds the menu cost that causes it. Michael Parkin also put forward the idea.George Akerlof and Janet Yellen put forward the idea that due to bounded rationality firms will not want to change their price unless the benefit is more than a small amount. This bounded rationality leads to inertia in nominal prices and wages which can lead to output fluctuating at constant nominal prices and wages. The menu cost idea was also extended to wages as well as prices by Olivier Blanchard and Nobuhiro Kiyotaki.

The new Keynesian explanation of price stickiness relied on introducing imperfect competition with price (and wage) setting agents. This started a shift in macroeconomics away from using the model of perfect competition with price taking agents to use imperfectly competitive equilibria with price and wage setting agents (mostly adopting monopolistic competition). Huw Dixon and Claus Hansen showed that even if menu costs were applied to a small sector of the economy, this would influence the rest of the economy and lead to prices in the rest of the economy becoming less responsive to changes in demand.

In 2007, Mikhail Golosov and Robert Lucas found that the size of the menu cost needed to match the micro-data of price adjustment inside an otherwise standard business cycle model is implausibly large to justify the menu-cost argument. The reason is that such models lack "real rigidity". This is a property that markups do not get squeezed by large adjustment in factor prices (such as wages) that could occur in response to the monetary shock. Modern New Keynesian models address this issue by assuming that the labor market is segmented, so that the expansion in employment by a given firm does not lead to lower profits for the other firms.

Magnitude of menu costs

When a company's menu costs a lot in economic markets, the price adjustment is usually major. The company would not engage in price adjustment if profit margins start to fall to the point where menu costs l