When Should a Company Change its Prices and Perform Menu Costs?

What are Menu Costs?

In economics, we use the term menu costs when we talk about the total sum of expenses that a company used in changing the price of a product or a service.

When a company changes their prices, they need to reprint menus, pricelists, change the tags on the shelf and stickers on the products. The cost refers to the expenses in the said activities, but it also refers to the lower revenue result after consumers realized that price raise.

Consumers, suppliers, and distributors may be hesitant to buy a product at a new and higher price.

However, when it is too expensive to have a menu cost, companies will usually opt not to adjust the price unless they are losing too much revenue because they are trying to avoid the menu cost.

Menu cost history and economists involved

In 1977, Yoram Weiss and Eytan Sheshinski introduced the term menu cost initially; however, from 1985 to 1986, new Keynesian economists like George Akerlof and Janet Yellen thought of applying menu costs as a standard theory on nominal price rigidity.

These two said that it is rational for firms not to change their pricing unless their returns would be higher than a very minimal amount.

If they change their price even with a minimal amount, prices and wages will remain small; then, output fluctuation is typically at small prices and wages.

Let’s explain menu costs further from the given history

Today, we can say that companies will have to think twice before changing their pricing. They can change their prices once the benefit is higher than a minimal amount, and this amount can also cover the expenses after a menu cost.

There should be enough difference between the company’s current pricing and the equilibrium market’s pricing.

The only problem is that it can be challenging to precisely identify the equilibrium market’s pricing or know how much a menu cost is.

Menu costs based on studies

Based on a study back in 1997, five supermarkets with several stores became subjects in finding out their exact menu cost. The results showed an average of 35% of net profit margins.

So, if a company wants to change prices, they will need to drop 35% of their profits first to realize the items’ final price update.

Studies also showed that menu costs could impact suppliers and distributors to the industries and markets due to nominal rigidity.

Menu costs are different from one industry to another. For example, some local regulations require a separate price tag that increases menu cost, or some suppliers with fixed contracts set price adjustment periods.

Some digital companies can update their prices in a few clicks, while some do not update their prices unless they need to.

Despite the usually higher price change, some drop their prices due to competition through promotions and discounts instead of an actual price change.

What is nominal rigidity?

Nominal rigidity is also known as price stickiness or wage stickiness. It means that the nominal price tends to resist changes. A complete nominal rigidity is a fixed price in nominal terms for a specific period.

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