Costs of Inflation: Shoe-leather Costs and Menu Costs - Online Tutor, Practice Problems & Exam Prep

Inflation incurs various costs, notably shoe leather costs, menu costs, and tax costs. Shoe leather costs arise from the inconvenience of frequently withdrawing cash to avoid holding depreciating money. Menu costs refer to the expenses businesses face when updating prices, such as reprinting menus. Tax costs occur when inflation creates phantom income, leading to taxation on gains that don't reflect real profit. Understanding these costs is crucial, especially in hyperinflation scenarios, where rapid price changes exacerbate these issues.

Costs of Inflation: Shoe-leather Costs, Menu Costs, and Tax Costs

Now let's see some of the side effects of inflation, some costs that occur because of inflation. So even if we perfectly anticipate inflation, we know how much inflation there's going to be, well, there are still going to be some costs that we must incur as a society. So let's check out these three that we've got listed here, the most common ones. The first one here is shoe leather cost, and this is resources wasted because you are trying to avoid holding money. Okay? The idea is that prices are going up, and like we've discussed in other videos, holding cash is bad when prices go up because the increased prices mean the cash is just going to be worth less. So this idea of shoe leather cost is the imagery of the wear and tear on your shoes running back and forth to the bank because of having to go to the bank so often because you need more cash or you need less cash, right? You're trying to avoid holding it. So in essence, what it really means is that time and convenience of holding less cash, right? You have to spend more time going to the bank because you don't want to hold it and you need it to earn the interest in the bank. It's not convenient to hold cash anymore because maybe now something costs, you know, if a gallon of milk costs $10,000, right? And now you have to pull $10,000 out of your pocket and you're carrying tons of cash around all the time, all these loads of cash, it's not convenient, right? So these are the shoe leather costs. And now typically, we have low inflation. This is a typical situation where we have low inflation, so it's usually trivial because it's not that big of a deal if the price of milk goes from $3 to $3.20 or something like that, you know, like it's not going to have so many shoe leather costs. Of course, that's a big increase in the price of milk, but it's not going to have a lot of shoe leather cost there. However, if it goes to hyperinflation like that situation where I said now a gallon of milk costs $10,000 and you're carrying all this cash, well, that's going to be pretty serious. So hyperinflation is extraordinarily rapid inflation. It's going to be a really high inflation rate. You're going to know if a professor is talking about hyperinflation. It's going to be an inflation rate generally above 50%, and it does happen. It's happened in recent history, in some countries in post World War I Germany, it happened and Zimbabwe saw hyperinflation, things like that. It does occur. So that's the first one, the shoe leather cost. Let's move on to the next one here, menu cost. So menu cost is the cost businesses face from changing prices. So when a business has to print new price tags out or a restaurant, this is the imagery that it's alluding to here. The menu cost is a restaurant having to print out a new menu because of the changed prices. How weird does it look when you go to a restaurant and you look at the menu and they've put a sticker over the price and you're like, oh man, I totally tell you raised the price on me. That's because they're trying to avoid these menu costs. They're just trying to put a little sticker to change to not have to print a whole new menu, right? Because of these increased costs, they have the increased prices. Now, so you can imagine the more regularly that you have to do this, well, the higher the menu costs are going to be. And what we'll see is in hyperinflation and situations of hyperinflation, imagine if those prices are changing daily, weekly, it's going to be a lot of menu cost because you have to constantly retag everything. Okay? The last one here is kind of interesting, the tax cost because if prices are rising, there might be phantom income that you've made, right? Maybe in our example, we have, you purchase land for $100,000 and there's 10% inflation. So that 10% inflation has brought the value of the land up to $110,000, you had a profit of $10,000. I'm going to tax you on that profit. However, did you really profit? The inflation is what caused that price to rise, not really profit, not really the market value of the land. It was just inflation. So you're going to still have to pay tax, but was it really a gain? Not really, right? We're seeing that the inflation caused the price to rise, so you don't really have any extra purchasing power with that $110,000, the prices have gone up by that same 10%. Cool? So that's about it here. The main ones you want to remember, the shoe leather, the menu, and the tax cost. I think shoe leather and menu cost because they have those funny names, they tend to come up just like multiple choice questions where they want to have you define it, something like that. But overall, pretty standard stuff here. Let's go ahead and move on to the next topic.

Here’s what students ask on this topic:

What are shoe leather costs in economics?

Shoe leather costs in economics refer to the resources wasted when people try to avoid holding money during inflation. As prices rise, holding cash becomes less desirable because its value decreases. The term 'shoe leather' comes from the imagery of people wearing out their shoes by frequently going to the bank to withdraw or deposit money. Essentially, it represents the time and inconvenience of managing cash more actively to minimize the loss of purchasing power. This cost is usually trivial in low inflation scenarios but becomes significant during hyperinflation.

How do menu costs affect businesses during inflation?

Menu costs are the expenses businesses incur when they have to update prices due to inflation. This can include reprinting menus, changing price tags, and updating digital systems. For example, a restaurant might need to print new menus to reflect higher prices, which can be costly and time-consuming. In hyperinflation scenarios, where prices change rapidly, these costs can become substantial as businesses must frequently update their prices to keep up with inflation. This not only affects their operational efficiency but also their profitability.

What is the impact of hyperinflation on shoe leather and menu costs?

Hyperinflation, defined as an inflation rate above 50%, significantly exacerbates both shoe leather and menu costs. For shoe leather costs, the rapid devaluation of money forces individuals to make frequent trips to the bank to manage their cash, leading to substantial time and effort wasted. For menu costs, businesses face the challenge of constantly updating prices, which can involve reprinting menus, changing price tags, and updating digital systems almost daily. This frequent need for adjustments increases operational costs and reduces efficiency, severely impacting both consumers and businesses.

Why are tax costs considered a consequence of inflation?

Tax costs are considered a consequence of inflation because inflation can create 'phantom income,' which is taxed as if it were real profit. For example, if you buy land for $100,000 and inflation is 10%, the land's value might rise to $110,000. Although this appears to be a $10,000 profit, it is merely a reflection of inflation, not an actual increase in purchasing power. However, you would still be taxed on this $10,000 gain, leading to a tax burden on income that doesn't represent real economic gain. This can distort financial decisions and reduce overall economic efficiency.

How do shoe leather costs and menu costs differ?

Shoe leather costs and menu costs are both consequences of inflation but affect different aspects of the economy. Shoe leather costs refer to the resources wasted by individuals trying to avoid holding depreciating cash, such as the time and effort spent making frequent trips to the bank. In contrast, menu costs are the expenses businesses incur when they have to update prices due to inflation, such as reprinting menus or changing price tags. While shoe leather costs impact consumers directly, menu costs primarily affect businesses, although both ultimately contribute to economic inefficiency.