In economics, a menu cost is the cost to a firm resulting from changing its prices. The name stems from the cost of restaurants literally printing new menus, but economists use it to refer to the costs of changing nominal prices in general. In this broader definition, menu costs might include updating computer systems, re-tagging items, and hiring consultants to develop new pricing strategies as well as the literal costs of printing menus. Because of this expense, firms sometimes do not always change their prices with every change in supply and demand, 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.
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 maximum 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.
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