What are the menu costs? You might think that's pretty straightforward - menu costs are the costs of printing menus. Well, yes, but there is more to it than just that. When firms decide to change their prices, there are a lot of costs that firms have to incur. You may not have thought of some of these costs before. Do you want to find out more about menu costs and their implications for the economy? Then keep on reading!
Menu Costs of Inflation?
Menu costs are one of the costs that inflation imposes on the economy. The term "menu costs" comes from the practice of restaurants having to change the prices listed on their menus in response to the changes in their input costs.
Menu costs refer to the costs of changing listed prices.
Menu costs include the costs of calculating what the new prices should be, printing new menus and catalogs, changing price tags in a store, delivering new price lists to customers, and changing advertisements. Besides these more obvious costs, menu costs even include the cost of customer dissatisfaction over price changes. Imagine that customers can be annoyed when they see higher prices and may decide to cut back on their purchases.
Because of all these costs that businesses have to bear when they change the listed prices of their goods and services, businesses usually change their prices at a low frequency, such as once a year. But during times of high inflation or even hyperinflation, firms may have to change their prices frequently to keep up with the rapidly rising input costs.
Menu Costs and Shoe Leather Costs
Like menu costs, shoe leather costs are another cost that inflation imposes on the economy. You might find the name "shoe leather costs" funny, and it draws the idea from the wear and tear of shoes. During times of high inflation and hyperinflation, the value of the official currency can decrease a lot during a short period of time. People and businesses have to quickly convert the currency into something else that holds a value which can be goods or foreign currency. Because people have to make more trips to the stores and banks to convert their currency into something else, their shoes wear out more quickly.
Shoe leather costs refer to the time, effort, and other resources spent on converting currency holdings into something else due to the depreciation of money during inflation.
You can find out more about it from our explanation on Shoe Leather Costs.
Also, check out our explanation on Unit of Account Costs to learn about another cost that inflation imposes on society.
Examples of Menu Costs
There are many examples of menu costs. For a supermarket, the menu costs include the costs of figuring out the new prices, printing out new price tags, sending out employees to change the price tags on the shelf, and printing out new advertisements. For a restaurant to change its prices, the menu costs include the time and effort spent on figuring out the new prices, the costs of printing new menus, changing the price display on the wall, and so on.
In times of high inflation and hyperinflation, very frequent price changes may become necessary for businesses to catch up with the costs of everything else and not lose money. When frequent price changes are necessary, businesses will try to avoid or at least reduce menu costs in this situation. In the case of a restaurant, a common practice is to not list prices on the menu. Diners will either have to inquire about the current prices or find them written on a whiteboard.
Other ways to reduce menu costs are also used by businesses, even in economies that do not experience high inflation. You may have seen these electronic price tags on the shelf of supermarkets. These electronic price tags enable the stores to easily change the listed prices and greatly reduce the costs of labor and supervision when a price change is necessary.
Menu Costs Estimation: A Study of US Supermarket Chains
You bet that economists have their attempts with menu cost estimation.
One academic study1 looks at four supermarket chains in the US and tries to estimate how much menu costs these firms might have to bear when they decide to change their prices.
The menu costs that this study measures include:
(1) the cost of labor that goes into changing the listed prices on the shelf;
(2) the costs of printing and delivering new price tags;
(3) the costs of mistakes that are made during the price change process;
(4) the cost of supervision during this process.
The study finds that, on average, it costs $0.52 per price change and $105,887 a year per store.1
This amounts to 0.7 percent of revenues and 35.2 percent of net margins for these stores.1
Menu Costs: Macroeconomic Implications
The existence of these substantial menu costs has important macroeconomic implications. Menu costs are one of the main explanations for the economic phenomenon of sticky prices.
Sticky prices refer to the phenomenon that the prices of goods and services tend to be inflexible and slow to change.
Price stickiness can explain short-run macroeconomic fluctuations such as changes in aggregate output and unemployment. To understand this, imagine a world where prices are perfectly flexible, meaning that firms can change their prices at no cost. In such a world, when firms face a demand shock, they can easily adjust the prices to accommodate the shifts in demand. Let's see this as an example.
There is a Chinese restaurant in the University District. This year, the university started to admit more students into their study programs. As a result, there are more students living around the University District, so there is now a larger customer base. This is a positive demand shock for the restaurant - the demand curve shifts to the right. To cope with this higher demand, the restaurant can raise the prices of their food accordingly so that the quantity demanded remains at the same level as before.
But the restaurant owner has to consider the menu costs - the time and effort put into estimating what the new prices should be, the costs of changing and printing new menus, and the very real risk that some customers will be annoyed by the higher prices and will decide not to eat there anymore. After thinking about these costs, the owner decides to not go through the trouble and keeps the prices as before.
Not surprisingly, the restaurant now has way more customers than before. The restaurant obviously has to meet this demand by making more food. To make more food and serve more customers, the restaurant also has to hire more workers.
In this example, we see that when a firm faces a positive demand shock and cannot raise its prices because menu costs are too high, it has to increase its production output and employ more people to respond to the increase in the quantity demanded of its goods or services.
The flip side is also true. When a firm faces a negative demand shock, it would want to reduce its prices. If it cannot change the prices due to high menu costs, it will face a lower quantity demanded of its goods or services. Then, it would have to cut its production output and reduce its workforce to cope with this drop in demand.
Fig. 1 - The costs of switching menus can be substantial and lead to sticky prices
What if the demand shock doesn't affect just one firm but a large section of the economy? Then the effect that we see will be so much larger through the multiplier effect.
When there is a general negative demand shock hitting the economy, a large number of firms will have to respond in some way. If they are not able to cut their prices because of menu costs, they will have to cut output and employment. When a lot of firms are doing this, it puts further downward pressure on aggregate demand: the downstream firms who supply them will also be affected, and more unemployed people will mean less money to spend.
In the opposite case, the economy can face a general positive demand shock. Many firms across the economy will like to increase their prices but can't do so because of high menu costs. As a result, they are increasing output and hiring more people. When many firms do this, this increases aggregate demand further.
The existence of menu costs causes price stickiness, which magnifies the impact of an initial demand shock. Because firms are not able to adjust prices easily, they have to respond through the output and employment channels. An exogenous positive demand shock can lead to a sustained economic boom and an overheating of the economy. On the other hand, an exogenous negative demand shock can develop into a recession.
See some terms here that you find interesting and want to learn more about?
Check out our explanations:
- The Multiplier Effect
- Sticky Prices
Menu Costs - Key takeaways
- Menu costs are one of the costs that inflation imposes on the economy.
- Menu costs refer to the costs of changing listed prices. These include the costs of calculating what the new prices should be, printing new menus and catalogs, changing price tags in a store, delivering new price lists to customers, changing advertisements, and even dealing with customer dissatisfaction over price changes.
- The existence of menu costs provides an explanation for the phenomenon of sticky prices.
- Sticky prices mean that firms have to respond to demand shocks through the output and employment channels instead of adjusting prices.
References
- Daniel Levy, Mark Bergen, Shantanu Dutta, Robert Venable, The Magnitude of Menu Costs: Direct Evidence from Large U.S. Supermarket Chains, The Quarterly Journal of Economics, Volume 112, Issue 3, August 1997, Pages 791–824, https://doi.org/10.1162/003355397555352
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