Market Failures Con't

Menu Prices:
In the beginning of any micro or macro- economics course, university students are taught about supply and demand curves. One of the fun things about continuing on in study is the ability to entertain ideas that turn that understanding on its head. For instance, 4th year students may be invited to throw out the supply and demand curve entirely.

In a normal supply and demand curve, any increase in demand (with the same supply) will increase the price of the good and over the long run invite new suppliers into the market to meet the new demand. If supply of a particular good increases (and demand remains the same), the price of the good immediately goes down until demand recovers and/or suppliers leave the marketplace.

A Keynesian critique of the law of supply and demand is “menu prices”. The term “menu prices” refers to the standard practice of businesses to figure out their costs and then charge a premium over those costs that is consistent with their industry. Supply and demand changes too quickly, is costly to calculate, and therefore difficult to implement price changes quickly. Managing to figure out costs and then charge a premium is a much simpler way for small businesses to operate. Plus, the internet can provide industry-specific mark-ups. Look at Inc. or Entrepreneur and one of the authors will encourage you to enter an industry with high margins (high mark-ups over costs).

If there were true supply and demand, a new entrant would enter the market to drive down these margins. Price stability, rather than the supply and demand curves and their fluctuating prices, is much more of the priority for our economy.

The specific term “menu prices” refers to the prices set by a local restaurant, which vary little over days or weeks. The owner of the restaurant believes that customers will become angry if she offers a hamburger for $4.00 Monday night but because business has been brisk in the days after, she is selling the same hamburger for $10 Friday night. This price instability endangers customer’s goodwill. She is also upset at having to print new menus every week, which can be expensive. Therefore, she keeps the value of price stability over fluctuations in price caused by demand or supply changes.

Since the free market dictates that prices change and change as often as each input (supply and/or demand) changes, there are only a few businesses that change their prices as frequently as supply and demand changes.

The problem that "menu prices" introduces into the market is a certain inertia that helps price stability but ensures a lack of true competition in certain industries. New suppliers entering a particular market with high margins have entered that market FOR its high margins and would not jeopardize those profits. So there are industry pockets that remain insulated from competition and the market. (Restaurant or medical equipment sales anyone?)