menu-costs

What are menu costs?

Menu costs describe any cost that a business must absorb when it decides to change its prices. The term itself references restaurants that must incur the cost of reprinting their menus every time they want to increase the price of an item. In an economic context, menu costs are expenses that are incurred whenever a business decides to change its prices.

Understanding menu costs

The theory behind menu costs harks back to the late 1970s with research performed by Israeli economists Eytan Sheshinski and Yoram Weiss. In more recent times, menu costs have been influenced by aspects of New Keynesian economics which promoted the idea that a business would only make price adjustments if the benefits of doing so outweighed the costs.

Menu costs are one explanation for sticky prices, or a tendency for the price of goods and services to remain static despite fluctuations in supply and demand. Menu costs also vary according to the industry or context. The restaurant, for example, will discover that it is more expensive to alter its printed menu prices than it is to alter online menu prices. Less literal examples of menu costs include the hiring of a consultant to identify profitable values and the installation of updated point-of-sale systems.

Implications of menu costs for businesses

Menu costs play a crucial role in determining how prices can be adjusted to an optimum level where profits are maximized, expenses are minimized, and consumer expectations are met. Every business should quantify its menu costs – not only to measure profitability but also to evaluate the capacity to adjust its prices in the first place. 

In a 1997 study entitled The Magnitude of Menu Costs: Direct Evidence From Large U.S. Supermarket Chains, the researchers noted that menu costs in five multi-store supermarket chains required dozens of steps and a significant investment. In fact, menu costs comprised 35.2% of net margins and cost 52 cents per change, with the cost per change increasing to $1.33 for supermarkets required by law to place a price on each item in addition to the shelf price.

The implications of this research for supermarkets and indeed other retail businesses are clear. No change in price should be made until the increase in revenue can compensate for the expenses incurred – though it can sometimes be problematic to determine the correct market equilibrium price. For the supermarkets in the above study, this meant the profitability of an item needed to drop by more than 35% to justify the cost associated with raising its price.

On occasion, it can also be difficult for a business to determine all relevant menu costs. One such cost that flies under the radar is the consumer reaction to an increase in price. In other words, will consumers become more hesitant to make a purchase? With shoppers now savvier than ever before and a diverse range of products on the market, there is a very real chance that an individual will simply choose to shop elsewhere.

Key takeaways:

  • In an economic context, menu costs are expenses that are incurred whenever a business decides to change its prices.
  • Menu costs play a crucial role in determining how prices can be adjusted to an optimum level where profits are maximized, expenses are minimized, and consumer expectations are met.
  • In theory, changing item prices should not occur until the increase in revenue can compensate for the expenses incurred. However, ascertaining the equilibrium point of the market may be more difficult in practice and the business must also consider the impact of the increased price on consumers. 

Connected Business Concepts

Revenue Modeling

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Revenue model patterns are a way for companies to monetize their business models. A revenue model pattern is a crucial building block of a business model because it informs how the company will generate short-term financial resources to invest back into the business. Thus, the way a company makes money will also influence its overall business model.

Pricing Strategies

pricing-strategies
A pricing strategy or model helps companies find the pricing formula in fit with their business models. Thus aligning the customer needs with the product type while trying to enable profitability for the company. A good pricing strategy aligns the customer with the company’s long term financial sustainability to build a solid business model.

Dynamic Pricing

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Price Sensitivity

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Price sensitivity can be explained using the price elasticity of demand, a concept in economics that measures the variation in product demand as the price of the product itself varies. In consumer behavior, price sensitivity describes and measures fluctuations in product demand as the price of that product changes.

Price Ceiling

price-ceiling
A price ceiling is a price control or limit on how high a price can be charged for a product, service, or commodity. Price ceilings are limits imposed on the price of a product, service, or commodity to protect consumers from prohibitively expensive items. These limits are usually imposed by the government but can also be set in the resale price maintenance (RPM) agreement between a product manufacturer and its distributors. 

Price Elasticity

price-elasticity
Price elasticity measures the responsiveness of the quantity demanded or supplied of a good to a change in its price. It can be described as elastic, where consumers are responsive to price changes, or inelastic, where consumers are less responsive to price changes. Price elasticity, therefore, is a measure of how consumers react to the price of products and services.

Economies of Scale

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In Economics, Economies of Scale is a theory for which, as companies grow, they gain cost advantages. More precisely, companies manage to benefit from these cost advantages as they grow, due to increased efficiency in production. Thus, as companies scale and increase production, a subsequent decrease in the costs associated with it will help the organization scale further.

Diseconomies of Scale

diseconomies-of-scale
In Economics, a Diseconomy of Scale happens when a company has grown so large that its costs per unit will start to increase. Thus, losing the benefits of scale. That can happen due to several factors arising as a company scales. From coordination issues to management inefficiencies and lack of proper communication flows.

Network Effects

network-effects
network effect is a phenomenon in which as more people or users join a platform, the more the value of the service offered by the platform improves for those joining afterward.

Negative Network Effects

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In a negative network effect as the network grows in usage or scale, the value of the platform might shrink. In platform business models network effects help the platform become more valuable for the next user joining. In negative network effects (congestion or pollution) reduce the value of the platform for the next user joining. 

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