What Are Menu Costs?
Menu costs are the expenses incurred by a business when it changes the prices of its goods or services. The term originates from the literal cost of reprinting menus in a restaurant, but it extends to any expense associated with adjusting prices, such as updating point-of-sale systems, re-labeling shelves, revising online product listings, or conducting new market analyses. Menu costs are a key concept in New Keynesian economics, which bridges microeconomic explanations of firm behavior with macroeconomic phenomena, particularly the concept of price stickiness. These costs can influence how frequently and quickly firms adjust prices in response to changes in underlying economic conditions, such as fluctuations in aggregate demand or supply costs.
History and Origin
The concept of menu costs was first formally introduced by economists Eytan Sheshinski and Yoram Weiss in their 1977 paper examining the effect of inflation on the frequency of price changes. They proposed that even in a fully anticipated inflationary environment, businesses would incur actual costs when changing prices, leading them to adjust prices in discrete jumps rather than continuously. The idea was later popularized and significantly expanded upon by New Keynesian economist N. Gregory Mankiw in his 1985 paper, "Small Menu Costs and Large Business Cycles: A Macroeconomic Model of Monopoly." Mankiw argued that even seemingly small menu costs could lead to substantial macroeconomic impacts, such as contributing to the observed sluggishness of prices to adjust to shocks and propagating business cycles. Other economists like George Akerlof and Janet Yellen also contributed to the theory, suggesting that firms might not change prices unless the benefits exceed a certain threshold, partly due to bounded rationality.4
Key Takeaways
- Menu costs represent the direct and indirect expenses businesses incur when altering their prices.
- They serve as a microeconomic explanation for price stickiness or nominal rigidity in macroeconomic models.
- These costs can deter firms from frequently adjusting prices, even when underlying economic conditions suggest a change is optimal.
- Examples include printing new labels, updating software systems, managerial decision-making time, and informing customers.
- Understanding menu costs helps explain why markets may not always reach economic equilibrium immediately after a shock.
Interpreting Menu Costs
Menu costs are not a numeric value to be interpreted in isolation but rather a qualitative factor that explains firm behavior and its aggregate effects. They are understood in the context of a firm's cost-benefit analysis regarding price adjustments. If the potential gain from changing a price (e.g., increased profit maximization from aligning with new supply and demand conditions) is less than the menu cost of making that change, a firm may choose to keep its prices constant. This reluctance can lead to prices that are "sticky," meaning they do not immediately respond to market shifts. The magnitude of menu costs varies significantly across industries and business models, influencing the degree of price rigidity observed in different sectors of an economy.
Hypothetical Example
Consider "Bella's Bakery," a small business that sells various baked goods. Bella prints glossy, colorful menus each quarter to display her prices.
One month into the quarter, the cost of flour and sugar unexpectedly rises significantly. According to her current pricing, Bella's profit margins on several items, particularly her popular croissants, are now very thin. Her optimal price for croissants might be $4.50, up from $4.00.
However, Bella calculates the menu costs associated with a price change:
- Designing and printing new laminated menus for all tables and the counter: $200
- Updating the digital menu board display: $50
- Staff time to learn and implement new pricing: $30
- Potential customer confusion or dissatisfaction from a mid-quarter price change.
The total tangible menu costs are $280. If Bella estimates that the increased revenue from raising the croissant price by $0.50 will only amount to an extra $200 in profit for the remainder of the quarter, she might decide that the transaction costs (menu costs) outweigh the benefit. In this scenario, Bella would absorb the higher input costs, keeping her prices "sticky" until the next scheduled menu update, even though a price increase is economically optimal.
Practical Applications
Menu costs have several practical implications across economic analysis and business strategy. They help economists understand why macroeconomic policy changes, such as shifts in monetary policy, may take time to fully impact prices and output. For businesses, menu costs influence pricing strategies. Companies with high menu costs might adopt less frequent price changes, implement more flexible pricing models (e.g., dynamic pricing for online services), or strategically delay adjustments.
For instance, during periods of rising inflation, firms face a decision: absorb higher input costs or pass them on to consumers by raising prices. The presence of menu costs can cause firms to delay price increases, contributing to a lag in the pass-through of inflationary pressures. Similarly, tariffs imposed on imported goods represent an increase in businesses' input costs. Businesses facing such tariffs must weigh the expense of adjusting prices against the loss of profitability from not doing so. Reports from July 2025 indicated that U.S. business activity picked up, but companies were also asking higher prices for goods and services, with tariffs cited as a factor fueling inflation concerns.3 Research by the Federal Reserve Bank of San Francisco has specifically explored the effects of tariffs on inflation and production costs, highlighting how such external factors necessitate pricing decisions from firms.2
Limitations and Criticisms
While menu costs offer a valuable explanation for price stickiness, the theory also faces limitations and criticisms. One challenge is empirically quantifying the precise magnitude of menu costs, as many are intangible, like managerial time spent on pricing decisions or the potential for customer backlash. Critics also point out that while menu costs can explain why prices are sticky, they may not fully account for the degree of price rigidity observed across an entire economy, especially in sectors with seemingly low direct costs of price adjustment (e.g., online retailers).
Alternative explanations for price stickiness exist, such as staggered price setting (where firms do not all change prices at the same time), implicit contracts between buyers and sellers, or "sticky information" models, where firms may not immediately have or process all relevant economic data. Some academic research acknowledges menu costs but also explores other factors that might contribute to nominal rigidity, such as idiosyncratic shocks or different price-setting mechanisms.1 The theory primarily focuses on the physical and decision-making costs, but other factors, such as psychological barriers to frequent price changes or concerns about competitive reactions, may also play significant roles.
Menu Costs vs. Price Stickiness
Menu costs and price stickiness are closely related but distinct concepts. Menu costs are a cause or microeconomic explanation for price stickiness, while price stickiness (also known as nominal rigidity) is the macroeconomic phenomenon itself. Price stickiness refers to the tendency of nominal prices for goods and services to adjust slowly in response to changes in the overall economic equilibrium. This means that if aggregate demand or supply shifts, prices may not immediately move to their new market-clearing levels. Menu costs, by making it expensive or inconvenient to change prices, provide a fundamental reason why firms might choose to maintain existing prices even when market conditions suggest otherwise, thereby contributing to this stickiness.
FAQs
What types of expenses are considered menu costs?
Menu costs include both direct and indirect expenses. Direct expenses can be tangible costs like printing new physical menus, price tags, or advertising materials, and updating software systems. Indirect expenses might involve the time spent by managers or employees analyzing market conditions, deciding on new prices, implementing changes, or communicating them to customers.
How do menu costs affect the economy?
Menu costs can lead to price stickiness, which in turn can cause the economy to adjust slowly to shocks. For example, if there's a sudden increase in aggregate demand, but firms face high menu costs, they might delay raising prices. This can lead to temporary changes in output and employment rather than immediate price adjustments, influencing the effectiveness of monetary policy and fiscal policy.
Are menu costs always financial?
No, menu costs are not always purely financial. While they include monetary expenses like printing or IT updates, they also encompass non-monetary costs such as managerial time, potential loss of customer goodwill due to frequent price changes, or the administrative burden of coordinating price adjustments across multiple sales channels.
Do menu costs apply to online businesses?
Yes, menu costs apply to online businesses, though the nature of the costs may differ. While online companies don't print physical menus, they still incur costs associated with updating website databases, reconfiguring e-commerce platforms, integrating with payment systems, or programming dynamic pricing algorithms. They might also face administrative costs related to adjusting prices for a large catalog of items or notifying customers of changes.
How do businesses try to reduce menu costs?
Businesses employ various strategies to mitigate menu costs. These include adopting digital pricing tools that allow for easier and faster price adjustments, implementing dynamic pricing models that automate changes based on real-time data, or scheduling price changes infrequently to minimize recurring expenses. Some firms also invest in technology to streamline the process of updating prices, thereby enhancing market efficiency.