Explaining the causes of the fast rise in the prices of goods and services in January, Lenno Uuskula, chief economist at Luminor, used the term “menu costs” from Keynesian economics to explain how the timing of major price hikes by sellers push up the overall price level more than the increase in input costs would call for.
Uuskula said that January surprised us with a very large increase in consumer prices, with prices rising by as much as 1.4 percent compared to December. Although this was partly driven by increases in the value-added tax and excise duties, some retailers and service providers raised prices significantly more. Uuskula ascribed this to the “menu cost” effect, which occurs when prices are changed not gradually but by a large amount and for all items at once, factoring in not only increased input costs but also prospective increases in inputs.
“In the context of the latest statistics, a person I know brought a good and vital example that illustrates the price change — the price of a haircut for a child, which used to cost 10 euros, including a month ago, was 15 euros at the beginning of February — that is, the service became 50 percent more expensive,” Uuskula said.
The term “menu cost,” originating in the restaurant business, explains price rigidity and a tendency of businesses to let input impacts accumulate and then to raise prices more and for the full menu at once, factoring in also further increases in inputs, in order to safeguard oneself against the need to have a new menu printed soon.
It’s clear that even though at the beginning of the year the value-added tax increased, fuel and electricity prices went up, and perhaps wages also were raised, the entire cost base could not have increased so much in a single month as to match the 50 percent rise in the cost of a haircut, he said.
“Clearly, behind this decision was the need to adjust the price, which had remained unchanged throughout the previous year, to cover the increased costs and to create a buffer for the coming months, so as not to introduce a new price list again in April or May. The increase in value-added tax provided a significant impetus for reviewing prices,” the economist said, adding that it makes sense for there to be a “pause in the printing of new menus now.”
It must be acknowledged, of course, that not all vendors changed their “menus” in January, in fact, some of them already started to do so at the end of last year, as the pending tax rises created a favorable environment, he said.
“We have already seen a similar surge once before, during the big price hike in 2021-2022. Back then, too, there was a fear of rising costs and vendors opted for a forward-looking increase in prices above what the actual costs would have required,” Uuskula said. “Going forward, I would like to hope, both from the point of view of the Estonian people and businesses, that for the most part it makes sense for price increases to be over for now.”
According to Uuskula, on the one hand, this would reduce the wage pressures caused by soaring prices for consumer goods and services. It also has an important role to play for the tourism sector, as foreign tourism has not yet recovered from the blow it took as a result of COVID.
“Estonia is already a rather expensive country for European tourists. Not to mention, of course, Estonia’s exports more broadly, as the rapidly growing cost base significantly undermines the price competitiveness of our companies in foreign markets,” the economist added.
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