Menu costs

From Wikipedia, the free encyclopedia

In economics, menu costs are the costs to firms of updating menus, price lists, brochures, and other materials when prices change in an economy. Because this transaction cost exists, firms sometimes do not change their prices when the economy puts pressure on it, leading to price stickiness.

Generally, the effect on the firm of small shifts in price (by changes in supply and/or demand, or else because of slight adjustments in monetary policy) are relatively minor compared to the costs of notifying the public of this new information. Therefore, the firm would rather exist in slight disequilbrium than incur the menu costs.

[edit] Deeper analysis

Consider a hypothetical firm in a hypothetical economy, with a concave graph describing the relationship between the price of its good and the firm's corresponding profit. As always, the profit maximizing point lies at the very top for the curve.

Now suppose that there exists a drop in aggregate output. While this causes real wages to fall (shifting the profit curve upward, allowing more profit for the same price), it also diminishes demand for the firm's product (shifting the curve down). Suppose the net effect is a downward shift (as it usually is).

The result is a maximimum profit associated with a lower price (the max profit shifts to the left a bit, as a result of the profit curve moving). Suppose the old price (and thus the old maximizing profit price) was M and the new maximizing price is N. Also suppose the new maximum profit is B and new profit corresponding to the old price is A. Thus price M yields A in profit and price N yields B in profit.

Now suppose there is a menu cost, Z, in changing from price M to price N. Because the firm must pay Z to make this change, they will only pay it if Z < B-A. Thus tiny fluctuations in the economy leads to small differences in B and A so firms do not change their price, even if Z is small.

Note that if Z is zero, then prices will change all the time, allowing for firms to squeeze out every bit of profit from every change in the economy.