Menu Cost - History

History

The concept of a lump-sum cost (menu cost) to changing the price was originally introduced by Sheshinski and Weiss (1977) in their paper looking at the effect of inflation on the frequency of price-changes. The idea of applying it as a general theory of Nominal Price Rigidity was simultaneously put forward by several New Keynesian economists in 1985-6. George Akerlof and Janet Yellen put forward the idea that due to bounded rationality firms will not want to change their price unless the benefit is more than a small amount. This bounded rationality leads to inertia in nominal prices and wages which can lead to output fluctuating at constant nominal prices and wages. Gregory Mankiw took the menu-cost idea and focussed on the welfare effects of changes in output resulting from sticky prices. Michael Parkin also put forward the idea. The menu cost idea was also extended to wages as well as prices by Olivier Blanchard and Nobuhiro Kiyotaki.

The new Keynesian explanation of price stickiness relied on introducing imperfect competition with price (and wage) setting agents. This started a shift in macroeconomics away from using the model of perfect competition with price taking agents to using imperfectly competitive equilibria with price and wage setting agents (mostly adopting monopolistic competition). Huw Dixon and Claus Hansen showed that even if menu costs applied to a small sector of the economy, this would influence the rest of the economy and lead to prices in the rest of the economy becoming less responsive to changes in demand.