Menu Costs

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21 Aug, 2024

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Table Of Contents

What Are Menu Costs?

Menu costs arise when companies change the prices of their products or services. The prime purpose of this cost is to determine the effect of changing prices on the firm's transaction costs.

It is a microeconomic concept given by classical economists. Also, it acts as a major contributor to market inefficiencies. These small menu costs can cause fluctuations in the business cycles. However, these costs can cause huge welfare losses for the business.

What Are Menu Costs?

Menu costs are business charges arising when a company changes its product or service prices. Economists Eytan Sheshinski and Yoram Weiss gave this theory in 1977.
These costs occur when the profit levels decline below the equilibrium point. It serves as a support to the macroeconomic theory of price-stickiness.
The Mankiw menu cost theory states that small charges can lead to large welfare losses. However, firms can choose to reset prices per the firm's surplus.
Companies can adapt to various methods to cope with the rising costs.

Menu Costs In Economics Explained

Menu costs in economics refer to monetary charges resulting from changing prices. For example, restaurants keep changing their menus when prices increase. Menu costs theory acts as a support to the macroeconomic theory of price-stickiness. For example, a recession may occur if prices do not change with inflation. Classical and New Keynesian economists originally gave this theory in the late 20th century. Later, the application of the concept spread worldwide.

These charges usually arise when the profit levels drop the equilibrium. However, the rise in these costs depends on the firm, raw materials, and technology. For instance, a change in the cheese-making procedure can cause a rise in pizza prices in outlets. Despite this, firms are free to change or keep the prices the same.

Price adjustments are infrequent when these charges are high in a particular sector. In short, price changes depend on the firm's types and technological uses. In addition, higher new prices may make customers apprehensive about making purchases impacting potential purchases. Thus, firms consider changing these costs when the company's profit erodes due to greater revenue loss.

Menu Costs History

Two economists, Eytan Sheshinski and Yoram Weiss, first proposed the menu costs theory in 1977, before new Keynesian economics popularized the idea. Both economists argued that businesses would not change prices continuously during inflation. Instead, they follow a discrete (separate), repeated pattern. And it happens when a firm's fixed costs rise following revenue growth. In 1985, New Keynesian economist Gregory Mankiw added that even small menu costs could cause greater effects. Mankiw further stated that it creates insufficient fluctuations, pushing the equilibrium below the optimum range.

In contrast, American economists George Akerlof and Janet Yellen argued that businesses would not change the price unless there was a huge benefit. However, the effect does not stop at only prices. In 1987, French and Japanese economists Olivier Blanchard and Nobuhiro Kiyotaki extended how business menu costs affect wage rates. Later, many other economists like Mikhail Golosov, Robert Lucas, Huw Dixon, and Claus Hansen contributed to the theory.

Menu Costs Model

While the prices in the neoclassical models were flexible, the reverse is true in the Keynesian model. Here, the prices are sticky, meaning firms hesitate to change the prices unless there is a rising cost. And to prove this, Gregory Mankiw gave the Menu costs model in 1985. According to the theory, small costs can cause large welfare losses to the firm. However, sticky prices can benefit one but not the whole of society. So let us look at the expansion of Mankiw's model related to this concept:

1. When Demand Increases

When aggregate demand expands (increases), the welfare will rise or reduce but not more than the menu costs. So the firm will try to reset the prices to an optimal point where these costs get covered. Here, the producer surplus reduces and increases social welfare (customer benefits).

2. When Demand Is Lower Than Expected

When total demand is less than expected, the firm will try to change its price. A contraction in demand will possibly reduce the total surplus to larger than menu costs. Here, the welfare losses are more than the surplus profits. So, the firm will try to reduce the prices in this case; however, if they do not change the prices, the surplus is more than the menu costs.

Examples

Let us look at the examples of menu costs inflation to comprehend the concept better:

Example #1

Suppose fast food chain Pizza Hut is considering changing its menu prices at its outlets. However, due to the rising prices of groceries and cheese, they plan to increase the prices of their pizzas. The menu currently has pizzas ranging from $11 to $22. So, now the prices have increased by $2.5. As a result, Pizza Hut incurred a new expense called menu costs. So, they printed new menu catalogs, contacted distributors, and did similar things.

For every industry, these costs will differ. For example, some firms might have small costs adjustable with profits; however, if the price change does not create additional revenue, it becomes worthless.

Example #2

A recent article by CBC states that as inflation and global problems arise, restaurants and food chains are likely to increase their menu prices. In a report by Foodservices Facts, food restaurants in Canada expect a price rise of 7.8% by December 2022. The rising prices will result in rising menu costs and inflation for the food chain outlets. Another report states that average menu costs are $105,887 per year per store by a $0.52 change in prices.

Menu Costs And Phillips Curves

Menu costs and the Phillips Curve have a certain relationship between them. While the former responds to the price and aggregate demand, the latter deals with the wage rate and inflation. If the firm changes its prices during inflation, it will also impact its demand. Likewise, higher wages may increase a firm's productivity.

If the firm has enough workers to meet demand, it might not hire more. However, unfulfilled demand might lead to a change in labor demand. For example, if McDonald's did not serve certain customers, the brand value might drop. Thus, the company might fire some employees, thus leading to unemployment. Similarly, if the wage rate decreases, employees might leave the firm.

So the Phillips curve states that a one-percent inflation reduction can cause production to drop by 0.5%. As a result, the demand will also fall, and productivity will change. And if demand drops, the firm will change the prices. Thus, the menu costs will also fluctuate.

Frequently Asked Questions (FAQs)

What are the menu costs and shoe leather costs?

While the former is the costs incurred on price changing, the latter describes the costs incurred for holding money. For example, shoe leather costs include brokerage fees, bank charges, and others.

What is the main theme of the menu costs model?

The main theme of the model focuses more on how sticky prices can be privately beneficial to some. However, others (majorly society) might not feel the same.

Are menu costs the same as changing costs?

No, they are different. Changing costs, also known as switching costs, occur when customers switch to another brand or product. For example, higher switching costs can be less likely to make customers leave the brand.

What is the difference between menu costs and menu pricing?

While both sound the same, they have huge differences. For example, when a restaurant changes the prices of dishes, the cost is the menu cost. Menu pricing refers to the process of determining the prices of these items.