Menu costs are the costs incurred by a business when it changes the prices it offers to its customers. A classic example is a restaurant that has to physically print new menus when it changes the prices of its dishes. The main takeaway from menu costs is that some prices are sticky.
Menu Costs: Macroeconomic Implications
The existence of these substantial menu costs has important macroeconomic implications. Menu costs are one of the main explanations for the economic phenomenon of sticky prices.
Sticky prices refer to the phenomenon that the prices of goods and services tend to be inflexible and slow to change.
Price stickiness can explain short-run macroeconomic fluctuations such as changes in aggregate output and unemployment. To understand this, imagine a world where prices are perfectly flexible, meaning that firms can change their prices at no cost. In such a world, when firms face a demand shock, they can easily adjust the prices to accommodate the shifts in demand. Lets see this as an example.
There is a Chinese restaurant in the University District. This year, the university started to admit more students into their study programs. As a result, there are more students living around the University District, so there is now a larger customer base. This is a positive demand shock for the restaurant – the demand curve shifts to the right. To cope with this higher demand, the restaurant can raise the prices of their food accordingly so that the quantity demanded remains at the same level as before.
But the restaurant owner has to consider the menu costs – the time and effort put into estimating what the new prices should be, the costs of changing and printing new menus, and the very real risk that some customers will be annoyed by the higher prices and will decide not to eat there anymore. After thinking about these costs, the owner decides to not go through the trouble and keeps the prices as before.
Not surprisingly, the restaurant now has way more customers than before. The restaurant obviously has to meet this demand by making more food. To make more food and serve more customers, the restaurant also has to hire more workers.
In this example, we see that when a firm faces a positive demand shock and cannot raise its prices because menu costs are too high, it has to increase its production output and employ more people to respond to the increase in the quantity demanded of its goods or services.
The flip side is also true. When a firm faces a negative demand shock, it would want to reduce its prices. If it cannot change the prices due to high menu costs, it will face a lower quantity demanded of its goods or services. Then, it would have to cut its production output and reduce its workforce to cope with this drop in demand.
Fig. 1 – The costs of switching menus can be substantial and lead to sticky prices
What if the demand shock doesnt affect just one firm but a large section of the economy? Then the effect that we see will be so much larger through the multiplier effect.
When there is a general negative demand shock hitting the economy, a large number of firms will have to respond in some way. If they are not able to cut their prices because of menu costs, they will have to cut output and employment. When a lot of firms are doing this, it puts further downward pressure on aggregate demand: the downstream firms who supply them will also be affected, and more unemployed people will mean less money to spend.
In the opposite case, the economy can face a general positive demand shock. Many firms across the economy will like to increase their prices but cant do so because of high menu costs. As a result, they are increasing output and hiring more people. When many firms do this, this increases aggregate demand further.
The existence of menu costs causes price stickiness, which magnifies the impact of an initial demand shock. Because firms are not able to adjust prices easily, they have to respond through the output and employment channels. An exogenous positive demand shock can lead to a sustained economic boom and an overheating of the economy. On the other hand, an exogenous negative demand shock can develop into a recession.
See some terms here that you find interesting and want to learn more about?
Check out our explanations:
– The Multiplier Effect
Menu Costs and Shoe Leather Costs
Like menu costs, shoe leather costs are another cost that inflation imposes on the economy. You might find the name “shoe leather costs” funny, and it draws the idea from the wear and tear of shoes. During times of high inflation and hyperinflation, the value of the official currency can decrease a lot during a short period of time. People and businesses have to quickly convert the currency into something else that holds a value which can be goods or foreign currency. Because people have to make more trips to the stores and banks to convert their currency into something else, their shoes wear out more quickly.
Shoe leather costs refer to the time, effort, and other resources spent on converting currency holdings into something else due to the depreciation of money during inflation.
You can find out more about it from our explanation on Shoe Leather Costs.
Also, check out our explanation on Unit of Account Costs to learn about another cost that inflation imposes on society.
Food Costs Formula: How to Calculate Restaurant Food Cost Percentage (Updated)
FAQ
What are the effects of menu costs?
What is the meaning of menu price?
What is an example of a menu cost?
What are menu costs in relation to inflation?
How do you calculate menu costs?
The product cost percentage is calculated by dividing the ingredient cost per dish by the menu price. The menu price is the “sales” price. For example, if the ingredient cost for a particular dish is $20, and a 50% product cost is desired, the operator would divide $20 by .5 (the desired product cost %). $20/.5 yields a menu price of $40.
What are menu costs?
Menu costs in economics refers to the cost to a commercial enterprise resulting from a price change. The term originates from the catering business – when a restaurant changes its prices, it has to design and print new menus – this costs money. Economists use ‘menu costs’ when talking about the costs of changing nominal prices in general.
How do you price a menu?
There are two ways how a menu item’s selling price is determined. They’re food cost and gross profit margin. Both methods involve having a goal and working backward to determine the price that will get you there. The first and most common way to price a food menu is to start with each item’s ideal food cost and price to achieve it.
What factors affect menu prices?
Menu costs usually are the result of inflation. For example, if the cost of food, rent, or wages goes up, a restaurant will have to raise its prices to pay for the extra cost and to make the same profit. When raising prices, there are additional costs, such as printing new menus, updating the website, etc.