Menu Cost

Menu cost, a term which usually shows up when cost of inflations are of concern, is a common term in the model of New Keynesian Economics (NKE). NKE tries to explain why and how movements in nominal Aggregate Demand (AD) caused by changes in monetary policy, can affect real variables, i. e. real output. The fundamental explanation, which is also the central aspect of all Keynesian model, is “nominal rigidities”, sticky prices and wages.

NKE says that the rationales behind these nominal rigidities are due to: (a) the existence of small costs of changing prices, also known as menu cost and (b) the existence of long-term contracts, which is explained by the staggered price models. NKE provides microeconomic foundations for Keynesian economics as it models the effects of these micro-based costs and rigidities and shows that under these assumptions monetary policy can have large real effects. Menu cost is the cost of changing the price of firm’s goods. In the NKE model, it is a source of price stickiness.

There are many reasons why it is the source of price stickiness (Mishkin, 2012): (1) changing prices involves many hidden costs (2) Since collecting information is costly, firms and households engage in rational inattention by only making decisions about prices at infrequent intervals. Customers may not immediately notice the price reduction and that provides less incentive for firms to cut prices (3) Changing prices frequently may alienate customers. Aside from the reasons above, there are two major papers which discussed menu cost and why monopolists are reluctant to change prices, even in the fall of aggregate demand.

Firstly, we start off with Akerlof and Yellen’s paper on assuming “near rationality” that is equivalent to rationality subject to second-order costs of taking decisions (Akerlof & Yellen, 1985) and an extension of the paper done by Blancard and Kiyotaki (Blanchard & Kiyotaki, 1987). We first consider a monopoly firm, i, which has a value of function of . is the firm’s utility function which depends on its own price, Pi and demand (Y=M/P), giving . The envelope theorem then says that If P is already the profit-maximising price, there is no change in price P that could increase profits in terms of Vi for any given change in monetary supply.

Hence, . The effects on equilibrium as “first order” change shows that a change in M on the value of the firm is the same whether or not the firm adjust its price optimally. The firm’s loss from not adjusting its price to the new profit-maximizing level in response to a shock in the nominal money supply is “second order” small. The “second order” menu cost (larger than the second-order loss in value) will prevent each firm from changing its price given other prices. P1 V(P0,M1) P0 V(P,M0) V(P,M1) V(P,M) Figure 1 V(P1,M1) P1 V(P0,M1) P0 V(P,M0) V(P,M1) V(P,M) Figure 1 V(P1,M1)

A graphical interpretation to represent the theorem mentioned above is represented by Figure 1, which depicts the value functions of firms for M0 and M1, where the optimal price for M0 is P0 and the optimal price of M is P1. When there’s a decline in demand represented by M, the firm behaves inertially, leaving price at P0 will incur a loss, from failure to maximise at M1, equals to V(P1,M1)- V(P0,M1), which as shown by the graph is second order small. The intuitive explanation behind this is that the essential feature of optimal choice is indifference at the margin.

(Akerlof & Yellen, 1985) The benefit of changing price may be very small compared to leaving it fixed at the old price, thus it makes sense that a small menu cost of changing prices might prevent price changes occurring. Next we consider the second major paper by Mankiw (1985) on the possibly large macroeconomic effects of sticky prices resulting from small menu cost. We first consider a monopolist firm facing a linear demand curve with constant Marginal Cost and no fixed costs, making MC=AC. Profit is maximised at MR=MC and in this menu cost model, we assume that firm faces a menu costs, z, if it changes it price.

P0 Pm MC q0 qm P q Figure 2 A C B D P0 Pm MC q0 qm P q Figure 2 A C B D We now represent the effects of a decline in demand in a graphical form based on figure 2. (Mankiw, 1985) Now suppose that the firm sets nominal price a period ahead, Pm based on its expectation of the future demands, Ne, and it produces at quantity, qm. When there’s a decline in demand, N<Ne, the observed price will be at P0 instead of Pm, as lower aggregate demand causes the optimal point to move up the curve until price reaches P0.

In this case, the firm’s profits are lower by B-A, which is positive, since Pm is by definition the profit-maximizing price and any other price must give a lower profit. Total surplus is reduced by B+C. This shows that the reduction in aggregate demand causes a greater reduction in total welfare as compared to reduction in firm’s total profit. Firm will only adjust its price if menu cost, z is smaller than the net profit gain from adjusting price, B-A>z. From the standpoint of a welfare maximizing social planner, the firm should adjust its price if B+C>z.

There are three implications from this (Mankiw, 1985): (a) If the firm changes its price from P0 to Pm, it is socially optimal. If firm cuts price, B-A>z. Thus this proves that B+C > z+A+C > z. (b) If following a contraction in demand, where B+C>z>B-A, the firm will not cut its price even though it’s socially optimal. (c)Total welfare, measured by the sum of consumer and producer surplus is unambiguously reduced when there is a decline in demand. If the firm cuts its price in response, the contraction only has the menu cost z.

If not, then the contraction has probably much larger cost B+C. These implications show that menu cost z would induce non-adjustment by the firm when society would be better off if the price were changed. In the case of a demand reduction, the firm’s private incentives can be such that it finds it profit maximising not to adjust price, but the resulting net profit gain is small in comparison to the large net loss in welfare for society. In terms of output, for small changes in M, the loss of not adjusting price will be small in relation to the change in output.

The reason prices are downwardly rigid, is because there is an asymmetric display by this menu cost model between contractions and expansions of aggregate demand. Private incentives produce too much price adjustment following an expansion in AD and too little price adjustment following a contraction in AD. From the social planner’s viewpoint, the nominal price level may be “stuck” too high, but it is never “stuck” too low, allowing prices to be downwardly rigid, but not upwardly rigid.

(Mankiw, 1985) Menu cost model shows that private decisions that are optimal at the individual level, which gives rise to small private gains, generate sub-optimal welfare outcomes and large welfare losses for society. This essentially represents the basics of NKE which focuses on the macro impact of micro behaviour in the face of imperfections, which are the price adjustments (menu costs) and also the existence of imperfect competition as represented by the monopolist model. There have been many supports and criticisms on menu cost model in explaining price rigidity.

Based on Blinder’s interviews on reasons behind price adjustments among firms in an advanced industrialized economy (Blinder, 1991), menu cost is significantly present in 70% of the interviewed firms, but fewer than half of them think it’s an important factor in slowing down price responses. His results showed that there are stronger reasons behind price rigidity: (1) Price is but one of several elements to change in response of a decline in demand. Firms can shorten delivery lags and provide more auxiliary services to compensate (2) Coordination failure occurs when one firm will only cut price if other firms does (3) Pricings are cost-based.

This implies that menu costs seem of minor importance to price setters. Kashyap’s paper on evidence of sticky prices from retail catalogues (Kashyap, 1991) questions the reason behind the existence of menu cost. His paper present three basic facts: (1) nominal prices are typically fixed for more than a year, but time between changes are very irregular (2) prices change more often during periods of high overall inflation (3) When prices do change, changes are widely dispersed. There is empirical evidence of price rigidity but he finds the difficulty of identifying these menu costs disturbing.

He believes that the significance of menu costs will be reduced with more common automated pricing decisions with increased computerization and automatic indexing provisions will gain popularity. His research on the increase in the frequency of price changes in line with high inflation during the late 1970s shows that menu cost is not as binding during times of high inflation. Romer’s paper on the New Keynesian model (Romer, 1993) believes that menu cost does not constitute the cost of nominal price adjustment.

He argued that the fallacy underlying the common view that these represent costs of changing nominal prices is in thinking of leaving its nominal prices unchanged as the only way that a firm can “do nothing” about its price. He suggests that prices can be adjusted by many simple means – such as an increase of a given amount in each month or indexation to a price index that would involve no costs once put into place. In other words, he says that that fact that it is costly to inform customers of nominal price change is a consequence, not a cause, of the fact that prices are rigid.

He pointed out that Mankiw’s model cannot account for microeconomic evidence on the nature of firm’s pricing policies, and Kashyap’s paper didn’t show a substantial menu cost. He also argues that there are many pricing policies with involves small amount of lost profits, but why choose ones that involve considerable nominal rigidity, as discussed by Akerloff and Yellen. However, Levy et al’s paper on researching on the magnitude of menu cost from US supermarket chains (Levy, Bergen, Dutta, & Venable, 1997) provides empirical evidence on the existence of menu costs.

In a large supermarket chain, menu costs are: (1) the labor cost of changing shelf prices (2) cost of printing and delivering new price tags (3) cost of mistakes during price change (4) cost of in-store supervision of price change process. The annual menu cost constitutes the supermarket’s 0. 70% of revenue and 35. 2% of net profit margins. This paper also shows that menu cost is a barrier to price change, and proves the relationship that larger menu cost leads to lower frequency of price change activity.

This is shown through the example of products under the price law, which has a menu cost 2. 5 times larger than other products, has less frequent price adjustments. Even in cost-based price adjustments, when cost increases, 70-80% of the products undergo price adjustment, but 20-30% doesn’t because existing menu costs make price adjustment unprofitable. There is direct microeconomic evidence on the actual magnitude of menu cost and it is large enough to be capable of having a macroeconomic significance. In conclusion, based on cumulated evidence, there is price rigidity because menu costs are a significant barrier to price changes only if they are reinforced by other rigidities.

Real rigidities are forces that reduce the responsiveness of firm’s profit-maximizing prices to variations in aggregate output resulting from variation in aggregate demand and they explain short-run macroeconomic fluctuations. The extent of the other – “real” – rigidities can be measured by the responsiveness of the profit maximising price to a change in the money supply. The smaller is the change in the profit-maximising price following a monetary shock, the higher the degree of real rigidity. (Romer, University of California Berkeley, 2006)

Bibliography Akerlof, G. , & Yellen, J. (1985). Can Small Deviations From Rationality Make Significant Differences to Economic Equilibria? American Economic Review, 75(4), 708-19. Blanchard, O. , & Kiyotaki, N. (1987). Monopolistic Competition and the Effects of Aggregate Demand. American Economic Review, 77(4), 647-666. Blinder, A. (1991). Why Are Prices Sticky? Preliminary Results from an Interview Study. American Economic Review, 81(2), 89-100. Kashyap, A. (1991). Sticky Prices: New Evidence From Retail Catalogues.

Quarterly Journal of Economics, 110(1), 245-74. Levy, D. , Bergen, Dutta, & Venable. (1997). The Magnitude of Menu Costs: Direct Evidence From Large US Supermarket Chains. Quarterly Journal of Economics, 112(3), 791-825. Mankiw, N. G. (1985). Small menu costs and large business cycles: a macroeconomic model of monopoly. Quarterly Journal of Economics, 100, 529-37. Mishkin, F. (2012). Macroeconomics: Policy and Practice. Essex: Pearson Education Limited. Romer, D. (1993). The New Keynesian Synthesis. Journal of Economic Perspectives, 7(1), 5-22.