Inventories and the volatility of production

A stylized fact associated with inventory behavior is that the variance of production exceeds the variance of sales. This paper presents a model of production decisions with demand uncertainty that incorporates no nnegativity constraints on inventories. Even with no productivity shocks, optimal behavior by the firm is consistent with this stylized fact either if demand exhibits positive serial correlation, or if the firm can backlog excess demand. The reason is that a demand shock affects both the actual inventory level (given unchanged production) and the desired level. Production must replenish the stock and adjust to the new desired level. Copyright 1987 by American Economic Association.