Estimating menu costs in electronic markets

Menu costs, or price adjustment costs, refer to the total cost of changing the price of a product, which includes the physical cost of making the change as well as the managerial cost of making the price change decision. Prior work has presumed that online retailers face no menu costs, potentially leading to Bertrand competition and the Law of One Price. However, little empirical evidence exists to assess the assumption. The objective of this research is therefore to empirically assess the magnitude of menu costs faced by online retailers. Using a nine-month productlevel price and demand data from Amazon, we infer menu costs based on the retailer's price change decisions. A key challenge in this estimation is that price change decisions are driven by changes in a retailer's expectation of future demand, which is not directly observable by researchers. We use statistical methods to infer expected demand from realized demand, thus identifying the magnitude of price adjustment cost econometrically. We find that online retailers face non-negligible menu costs, representing about 0.2% of their gross revenues. Our results also reveal that menu costs at online retailers exhibit unique characteristics. Compared with prior studies in physical retailers, the result shows that online retailers incur significantly higher menu costs per price change, but the costs account for a lower proportion of the total revenue. We attribute this phenomenon to the scale economies of online retailers.