Menu Costs and Nominal Rigidities: The Mankiw Model

Imagine you’re running a small café. Business has been slower than usual, and logically, you should drop your prices to attract more customers. But when you think about reprinting menus, updating your digital displays, and explaining the new pricing to confused customers, you decide to wait. This seemingly minor hesitation-multiplied across thousands of businesses-can help explain why entire economies sometimes get stuck in recessions. Welcome to the world of menu costs and nominal rigidities.

What are menu costs? 🔗

At its most literal, menu costs refer to the expenses restaurants face when printing new menus. But economists use the term more broadly to describe all the costs that firms incur when changing prices. These include updating computer systems, re-tagging items, changing signage, informing customers, and even the potential loss of customer trust from frequent price changes.

Think of a supermarket chain. A 1997 study examining five major U.S. supermarket chains found that menu costs averaged around $105,887 per year per store, comprising about 0.7% of revenue and an astounding 32.5% of net margins. For a price change to be worthwhile, profitability needed to decrease by more than 32.5%. These aren’t trivial numbers-they’re significant enough to influence business decisions about when and whether to adjust prices.

While the costs might seem small from an individual firm’s perspective, their impact ripples through the entire economy. When prices don’t adjust smoothly to economic changes, we get what economists call nominal rigidities-the tendency of prices to remain sticky rather than flexibly responding to market conditions.

The Mankiw model: when small costs create big effects 🔗

In 1985, economist N. Gregory Mankiw developed an elegant model that showed how tiny menu costs could have outsized macroeconomic consequences. His insight was deceptively simple: even small menu costs can create inefficient price adjustment and push the economy below socially optimal levels.

The private calculus of price changes 🔗

Here’s how Mankiw’s model works. Consider a firm operating in an imperfectly competitive market-meaning it has some pricing power, unlike firms in perfectly competitive markets. When demand contracts, this firm could lower its price to stimulate sales. But should it?

The firm weighs two things: the additional profit from cutting prices versus the menu cost of making that change. If the firm has already set a price above its optimal level due to a previous demand shock, cutting the price would increase profits. But-and this is crucial-the private benefit of a small price adjustment can be minuscule for the firm, especially when demand is relatively inelastic.

Mankiw showed mathematically that following a contraction in demand, a firm might rationally choose not to cut its price even when doing so would increase social welfare. The private profit gain might be smaller than the menu cost, making price rigidity the firm’s optimal choice. This creates what economists call downward price stickiness-prices resist falling even when economic logic suggests they should.

When demand expands versus contracts 🔗

Interestingly, the model behaves differently depending on whether demand increases or decreases. When demand expands, firms are much more willing to raise prices because the profit gains are typically larger and more immediate. But when demand contracts, the asymmetry kicks in. Mankiw demonstrates that private incentives ensure high price adjustment when aggregate demand expands, but only small adjustment following a contraction.

This asymmetry has profound implications. From a social planner’s perspective, prices may get stuck too high during downturns, but they’re never stuck too low during booms. This helps explain why recessions can be so persistent and painful.

The aggregate consequences: from micro to macro 🔗

The real magic-or perhaps curse-of menu costs emerges when we scale up from individual firms to the entire economy. When thousands of firms face the same calculus simultaneously, the aggregate price level becomes rigid. This price stickiness transforms how monetary policy affects the real economy.

Consider what happens when the central bank increases the money supply during a recession. If prices were perfectly flexible, they would adjust immediately, leaving real economic activity unchanged-what economists call monetary neutrality. But with sticky prices, something different occurs.

When the money supply increases but prices remain stuck, the real money supply actually increases. This stimulates economic output through multiple channels: lower real interest rates encourage borrowing and investment, real-balance effects make consumers feel wealthier and increase spending, and firms find it profitable to expand production. This provides a microeconomic foundation for Keynesian theories about how monetary policy can affect real economic variables like employment and output.

The spillover effect across sectors 🔗

Even more remarkably, research by economists Huw Dixon and Claus Hansen revealed that even if menu costs apply to only a small sector of the economy, this influences the rest of the economy and leads to prices becoming less responsive to demand changes everywhere. Think of it as price stickiness contagion-when some firms keep their prices fixed, it affects pricing decisions throughout the supply chain and across related markets.

The critical divergence: private versus social costs 🔗

Perhaps the most important insight from the Mankiw model is the gap between private and social benefits of price adjustment. This divergence explains why individual rationality can lead to collective inefficiency.

From a private firm’s perspective, the benefit of changing prices is measured purely in terms of increased profits. This benefit might be quite small-perhaps just a second-order effect on the firm’s bottom line. If this potential profit gain is smaller than the menu cost, the rational choice is to leave prices unchanged.

But from society’s perspective, the calculation looks very different. Flexible prices help coordinate economic activity and prevent unemployment. When prices stick too high during a recession, resources sit idle-workers remain unemployed, factories operate below capacity, and economic potential goes unrealized. The social cost of this unemployment far exceeds the firm’s private menu cost.

To illustrate with numbers: imagine a firm facing a menu cost of $1,000 and a potential private profit increase of only $500 from cutting prices. Rationally, the firm keeps its price unchanged. But if that price rigidity contributes to persistent unemployment affecting hundreds of workers, the social welfare loss could be orders of magnitude larger than the $1,000 menu cost.

The externality problem 🔗

This creates what economists call an externality-the firm’s pricing decision imposes costs on others that the firm doesn’t account for in its private calculations. The firm bears the menu cost privately but doesn’t capture the social benefits of having more flexible prices that could help the economy adjust more smoothly to shocks.

This market failure suggests a potential role for policy intervention. Active monetary policy, tax-based incomes policies, or supply-side measures might help alleviate the coordination problems that arise when private incentives diverge from social welfare. Central banks, understanding these dynamics, often act more aggressively during downturns to compensate for price stickiness.

Real-world evidence and modern developments 🔗

While the Mankiw model provides elegant theoretical insights, does it hold up in reality? The evidence is mixed but generally supportive. Studies across multiple countries consistently show that prices remain fixed for considerable periods-often around 12 months on average when temporary sales are excluded.

However, the digital age is changing this landscape. Research on online retailers like Amazon Fresh found that products had an average of 20.4 price changes per year with a median magnitude of 10%. Automated pricing algorithms reduce menu costs dramatically, allowing real-time responses to market conditions. This decreased rigidity might fundamentally alter how monetary policy transmits through the economy.

There’s also ongoing debate about whether menu costs alone can generate sufficient nominal rigidity to match empirical patterns. Some economists argue that models need additional features like “real rigidities”-factors such as imperfect competition or wage contracts that make firms reluctant to change relative prices even absent menu costs.

What do you think? If technology is making price changes nearly costless for digital businesses, will the traditional mechanisms by which monetary policy affects the real economy weaken? And in a world where some prices adjust instantly while others remain sticky, how should policymakers navigate these mixed dynamics?

References

1. https://en.wikipedia.org/wiki/Menu_cost
2. https://policonomics.com/mankiw-menu-cost/
3. https://en.wikipedia.org/wiki/Nominal_rigidity