When small costs make big impacts: Vertical contracts with menu costs

Retailers incur price-adjustment costs called menu costs when changing the prices of their products over time. These products are often sourced from upstream suppliers, who endogenously determine wholesale prices, which have cascading effects on retail prices. In this paper, we consider the pricing strategies of supply chain members in the presence of menu costs. Our analysis suggests that even a minuscule menu cost can substantially affect pricing strategies and the equilibrium outcome. Upstream manufacturers always benefit from a menu cost whereas downstream retailers benefit from only a moderate menu cost and are hurt by both high and low menu costs. Meanwhile, menu costs always alleviate the issue of double marginalization, thereby improving supply chain profits, consumer surplus, and social welfare. This study provides channel members with guidance on how to set prices in the presence of menu costs. It also recommends retailers to optimally maintain a moderate menu cost.