The case of a fall in aggregate demand could be analysed in the similar way (See figure 2 in appendix). The firm ignores the macroeconomic externality when making its decision, so it may decide not to pay the menu cost and cut its price even though the price cut is socially desirable. The resulting profit gain for the firm from not to adjust price will be small in comparison to the large welfare loss for society. Hence, sticky prices may be optimal for those setting prices, even though they are undesirable for the economy as a whole.
Now the role of menu costs is clear. For New Keynesians, the importance of price stickiness is that it helps explain monetary nonneutrality. Menu costs hence have important macroeconomic implications. First, menu costs can be a source of price rigidity and thus provide a micro-based explanation for monetary nonneutrality. Second, even small menu costs may be sufficient to generate substantial aggregate nominal rigidity and large business cycles.
However, despite the important role of menu costs in New Keynesian models, economists disagree about whether menu costs explain the short-run stickiness of prices. What will the empirical evidence tell us? Is there evidence to support the menu costs theory?
The behaviour of L.L.Bean (a US mail-order clothing company) catalog prices, documented by Kashyap in 1991 illustrated little evidence of menu costs on the nature of firms’ pricing policies. Bean issues over 20 catalogs every year, changing the prices listed in a new catalogue is virtually costless. Yet Kashyap found that the nominal prices of many goods remained fixed in successive issues of the catalogue, only changed in two of the catalogs (Fall and Spring). Neither fact supported the view that the cost of printing and posting a new price is the barrier to price adjustment. When nominal prices were changed, Kashyap found both large and small changes. He interpreted the combination of small price changes and long periods of unchanged prices as evidence against menu costs. If menu costs are the reason that prices are not changed frequently, prices should be changed only when they are relatively far out of line, and the price changes should be large; small changes seem to contradict this implication of menu costs.
Also in 1991, Alan Blinder attacked price stickiness directly by surveying firms about their price-adjustment decisions. Blinder began by asking firm managers how often they change prices and the answers were summarized in table 1.
This implies GDP is re-priced quarterly or less often. Firms seem to adjust their prices in response to a significant demand or cost shock with a lag of 3-4 months. Product prices do seem to be sticky.
Blinder then asked the firm managers why they do not change prices more often. He explained to the managers 12 economic theories of sticky prices and asked them to judge how well each of these theories describe their firms. The results were summarized in table 2.
Both menu costs and convex costs were lumped together in this table, but Blinder distinguished the two by asking all two hundred firms about their pricing practices and the answers are shown in table 3.
The votes pointed overwhelmingly toward menu costs. The impression that menu costs are the dominant form of adjustment costs was strongly confirmed.
Blinder concluded that first, about 70 percent of all firms reported that they have special costs of price adjustment. Second, there were strong indications that adjustment costs for changing prices are more often menu costs than convex. Empirical findings that some firms make very small price changes should not be construed as rejection of the menu-cost theory. Third, fewer than half thought adjustment costs an important factor in slowing down price responses.
Another study was carried out by Daniel Levy, Mark Bergen, Shantanu Dutta and Robert Venable in 1997. They measured menu costs of five large US retail supermarket chains and provided evidence that menu costs may form a barrier to price changes. First, they contrasted the price change activity of a chain that operates in a state with an item pricing law with another four chains that operate in states not subject to such laws. They showed that the average menu cost per price change for the chain subject to the item pricing law was $1.33, over two and a half times the cost for the other four, $0.52. Hence supermarket chains not subject to item pricing law changed prices two and a half times more frequently than the chain that is subject to the law. Second, within the chain facing the item pricing law, there are 400 products that are exempt from this law so they faced lower menu costs. Levy et al showed that for these products the chain each week changed the prices of 21 percent of the products on average, which was three times more frequently than for products subject to the law. Third, they found that the chains not subject to item pricing laws every week experienced cost increases on about 800-1000 products they sold. Yet, they adjusted prices of only about 70-80 percent of these products. The remaining 20-30 percent of the prices were not adjusted immediately because the existing menu costs made the necessary price adjustment unprofitable. Levy et al’s findings offered direct support for the relationship between menu costs and store-level individual price rigidity.
To conclude, menu cost is important in New Keynesian economics as it helps to explain the price stickiness which is in turn the explanation of monetary nonneutrality. In addition, it is a classic example of macroeconomic externality and has big macroeconomic implication – small menu costs but large business cycles. The empirical evidence told us that menu costs did appear to play a role for many firms. However, menu costs by themselves are unlikely to generate substantial nominal price rigidity. But they may have the effect of keeping nominal prices unchanged to become equivalent to “doing nothing,” and thereby generate considerable rigidity. The end result is likely to be that menu costs are a significant barrier to price changes only if they are reinforced by other rigidities such as nominal wage rigidity. Nominal price stickiness may be both stronger and more complicated than it would be if menu costs alone were the only frictions.
R. J. Gordon (2000) Macroeconomics (8th edition) Chapter 17, sections 17.6-17.11
G. N. Mankiw (1985) “Small menu costs and large business cycles: a macroeconomic model of monopoly” Quarterly Journal of Economics 100, P529-537
D. Romer (2000) Advanced Macroeconomics (2nd edition) Chapter 6 Part C
N. G. Mankiw (2000) Macroeconomics (4th edition) Chapter 19, P515-525
A. Abel, B. Bernanke, R McNabb (1998) Macroeconomics Chapter 12
- S. Blinder (1994) “On sticky prices: academic theories meet the real world” Chapter 4 in N. G. Mankiw (ed) Monetary Policy University of Chicago Press
H. D. Dixon (1997) “The role of imperfect competition in new Keynesian economics”
Chapter 7 in B. Snowden and H. R. Vane (eds) Reflections on the development of modern macroeconomics, Edward Elgar
A. K. Kashyap (1991) “Sticky prices: new evidence from retail catalogs” Quarterly Journal of Economics, P245-274
D. Romer (1993) “The New Keynesian Synthesis”, Journal of Economic Perspectives, P6-22
D. Levy et al (1997) “The magnitude of menu costs: direct evidence from large US supermarket chains” Quarterly Journal of Economics P791-825